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A market economy is an economic system in which the production and distribution of goods and services takes place primarily through the mechanisms of the market.^[1] In a market economy, resources are allocated as a result of individual decision making. Individuals and corporations are responsible for most economic choices, being constrained only by the quantity of resources they control. Those who control more resources have more choices available to them than those who control fewer resources.^[2]

A market economy uses prices to determine the allocation of goods and services; those prices, in turn, are determined by supply and demand on the open market for the goods and services in question. Thus, a market economy is composed of an intricate web of interconnecting markets.

Market economies are strongly associated with the concept of capitalism and with private ownership over the means of production. Most - perhaps all - market economies in history have been capitalist economies. Nevertheless, it is possible for a non-capitalist market economy to exist. The economic system known as market socialism, in which the means of production are owned by the state but most goods are allocated through the market, is an example of such an economy.^[3]

Economic indicators[edit]

Economists generally agree that the three most important indicators of the performance of a market economy are the total aggregate wealth, the level of employment and the price level. Based on this, they conclude that the goals of economic policy are to promote economic growth, to achieve full employment and to maintain price stability.^[4] Thus, the main challenges faced by a market economy are economic recessions, unemployment and inflation.

However, precisely because a market economy is not centrally directed by a government or any other single organization, information about the state of the economy is not immediately available to researchers. Various measurements are used to determine the total wealth, level of employment and price level within a market economy at a given time.

Wealth is commonly measured using the Gross Domestic Product, which reflects the market value of all final goods and services produced within a country in a given period of time (usually one year). The unemployment rate is measured differently in different countries, but is generally understood as representing the number of people who are willing to work but unable to find employment, as a fraction of the total labor force. The price level is often measured using the consumer price index, which is a price index that tracks the prices of a specified basket of consumer goods and services.

Types of markets[edit]

A market economy is composed of three fundamental types of markets. In consumer markets, goods and services are sold by businesses and bought by private individuals and households. In labor markets, workers sell their labor-time to businesses. In financial markets, money itself is bought and sold, for a price called the interest rate.

Together, the three types of markets create a circuit through which money and goods flow continuously, in opposite directions. Money, for example, flows from consumers to businesses through real markets and returns to consumers in labor markets; at the same time, money flows between creditors and debitors in financial markets.

The economic circuit is almost never completely closed. The government can act as a buyer or seller in most markets, and can influence the economy through its policy on taxes and spending. Also, most modern market economies are open to trade with the economies of other countries, and are therefore influenced by events taking place in foreign markets.

The business cycle[edit]

The business cycle is a feature of market economies that has been the object of extensive research and controversy. It has been observed that economic activity within a market economy fluctuates around its long term growth trend. This cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product. The business cycle does not follow a purely mechanical or predictable periodic pattern, but it does occur with some degree of regularity.

The goal of finding an explanation for the business cycle - and, perhaps, a way to eliminate it or mitigate its effects - has been a primary concern of macroeconomics over the past century. The Great Depression, in particular, was an unusually severe recession that continues to fuel debates among economists even to this day. Some major macroeconomic models are detailed below.

Macroeconomic models[edit]

Several schools of economic thought have designed macroeconomic models in an attempt to describe the structure of a market economy and make policy recommendations.

The classical and neoclassical schools take a supply-side approach and argue that a market economy is self-adjusting. Classical economists believe that, in the absence of government intervention, a market economy will naturally tend towards the full employment level. In the classical model, this is achieved through self-stabilizing mechanisms such as a floating interest rate and flexible prices and wages.^[5]

Keynesian economics was founded by British economist John Maynard Keynes, and it developed against the background of the Great Depression in the 1930s. Contrary to the views of the classical economists, Keynesian economics argues that a market economy does not naturally tend towards full employment, and that it is possible to have persistently high levels of unemployment throughout the business cycle. In the Keynesian view, changes in the autonomous elements of aggregate demand, especially investment demand, are key factors causing changes in the equilibrium level of income. According to Keynesian economics, government intervention is necessary to bring the economy back to full employment after a recession and to counteract the effects of the business cycle. Further, Keynesians believe that the most effective form of government intervention is fiscal policy (that is, policy on taxation and government spending).^[6]

The monetarist school accepts some of the conclusions of Keynesian economics (specifically, that a market economy will not naturally tend towards equilibrium, at least not in the short run), but argues that fiscal policy is ineffective. Monetarists place a particularly high importance on the money supply as the main factor behind fluctuations in national income and the business cycle. They believe that the business cycle is fundamentally caused by faulty monetary policy - especially in the form of inflationary policies adopted by central banks - and they believe that monetary policy is also the only mechanism that can effectively stabilize the economy.^[7]

Notes and References[edit]

^ "market economy", The New Dictionary of Cultural Literacy, Third Edition. 2002.
^ Lieberman, Marc and Hall, Robert E. "Introduction to economics", Thomson Learning, 2005. pp. 43
^ Lieberman, Marc and Hall, Robert E. "Introduction to economics", Thomson Learning, 2005. pp. 47
^ Lieberman, Marc and Hall, Robert E. "Introduction to economics", Thomson Learning, 2005. pp. 350
^ Froyen, Richard T. "Macroeconomics: Theories and policies", Pearson Prentice Hall, 2005. pp. 74
^ Froyen, Richard T. "Macroeconomics: Theories and policies", Pearson Prentice Hall, 2005. pp. 119
^ Froyen, Richard T. "Macroeconomics: Theories and policies", Pearson Prentice Hall, 2005. pp. 239-240