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• Origin of Free Markets

Pillars of the Market Economy

Free markets vs. capitalism.

• Historical Resistance to Markets
• Market Economy History FAQs

Market Economy: Brief History, Features, How It Works

The free market describes an economic system where people voluntarily trade with one another in their own self-interest. A purely free market has little to no government intervention or regulation, and individuals and companies are free to trade as they please.

The market economy has existed in various forms ever since human beings began trading with one another. Free markets emerged as a natural process of social coordination, not unlike language. No single intellectual invented voluntary exchange or private property rights ; it likely emerged as the natural outcome of human behavior.

Key Takeaways

• A free market is one where voluntary exchange and the laws of supply and demand provide the sole basis for the economic system, with minimal government intervention.
• A key feature of free markets is the absence of coerced (forced) transactions or conditions on transactions.
• Nobody invented the free market; it arose organically as a social institution for trade and commerce.
• While some free-trade purists oppose all government intervention and regulation, certain legal frames such as private property rights, limited liability, and bankruptcy laws have helped stimulate free markets.

Where Did the Free Market Come From?

Even without money, human beings engaged in trade with one another. Evidence of this stretches back far further than written history. Trade was informal initially, but economic participants eventually realized that a monetary medium of exchange would help facilitate these beneficial transactions.

The oldest known media of exchange were agricultural goods—such as grain or cattle—likely as far back as 9000 to 6000 B.C. It wasn't until around 1000 B.C. that metallic coins were minted in China and Mesopotamia and became the first known example of a good that functioned only as money.

While there is evidence of banking systems in early Mesopotamia and ancient Rome, the concept wouldn't emerge again until the 15th century in Europe. This did not occur without significant resistance; the church initially condemned usury . Slowly thereafter, merchants and wealthy explorers began to change the notions of business and entrepreneurship .

There are two pillars of the market economy: voluntary exchange and private property. It is possible for trade to occur without one or the other, but that wouldn't be a market economy—it would be a centralized one.

Private property has existed long before written history, but important intellectual arguments in favor of a private system of ownership of the means of production would not be made until John Locke in the 17th and 18th centuries.

Purely free markets are extremely rare in the modern world, as almost every country intervenes through taxes and regulations. The majority of countries in the world can be better described as mixed economies .

It is important to distinguish free markets from capitalism . Capitalism is an organizational system of how goods are created—where business owners and investors (capitalists) assemble productive resources in a centralized entity, such as a company or corporation.

These business owners own all of the tools, machinery, and other resources used in production, and keep the majority of the profits. In turn, they hire employees as labor in return for salaries or wages. Labor does not own any of the tools, raw materials, finished products, or profits—they only work for a wage.

On the other hand, a free market describes how the laws of supply and demand will be affected by the decisions of economic actors. A free market may describe the behavior of consumers in industrial capitalism, but it can also refer to the interactions between traders in preagricultural societies.

Historical Resistance to Market Forces

Many historical advances in free-market practices have been opposed by existing elites. For instance, the market tendency toward specialization and division of labor ran counter to the existing caste system in feudal Europe among the aristocracy.

Mass production and factory work were similarly challenged by politically connected guildsmen. Technological change was famously attacked by the Luddites between 1811 and 1817. Karl Marx believed that the state should take away all private ownership of the means of production.

Central authority and government planning have stood as the primary challengers to the market economy throughout history. In contemporary language, this is often presented as socialism versus capitalism. While technical distinctions can be drawn between common interpretations of these words and their actual meanings, they represent the modern manifestations of the conflict between voluntary markets and government control.

Most contemporary economists agree that the market economy is more productive and operates more efficiently than centrally planned economies. Even so, there is still considerable debate as to the correct degree of government intervention in economic affairs.

Who Discovered the Principles of the Market Economy?

The study of market economics is frequently traced to Adam Smith , who described the relations between producers and consumers in The Wealth of Nations. David Ricardo later formalized a mathematical model of this relationship in The Principles of Political Economy and Taxation.

What Are the Features of a Market Economy?

Market economies are characterized by the existence of private property and voluntary transactions between economic actors. Although there may be some involuntary transactions, such as taxes , the producers and consumers in a market economy are largely free to pursue their own self-interests.

How Does a Market Economy Work?

In a market economy, resource allocation is determined by the result of many tiny decisions by thousands of economic actors behaving in their own self-interest. Whenever certain products are in high demand, prices for that product tend to rise, creating a financial incentive for producers to increase production. This is the opposite of a command economy , where resources are allocated by a central authority.

NOVA (PBS). " The History of Money ."

World History Encyclopedia. " Banking in the Roman World ."

John Locke. "Second Treatise of Government: An Essay Concerning the True Original, Extent and End of Civil Government." John Wiley & Sons, 2014.

Jason W. Moore. " Nature and the Transition from Feudalism to Capitalism ." Pages 97-172.

Astarita, Carlos. " Karl Marx and the Transition From Feudalism to Capitalism ." International Critical Thought , vol. 8, no. 2, 2018, pp. 249-263.

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Market systems

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The evolution of capitalism

From mercantilism to commercial capitalism.

It is usual to describe the earliest stages of capitalism as mercantilism , the word denoting the central importance of the merchant overseas traders who rose to prominence in 17th- and 18th-century England, Germany, and the Low Countries . In numerous pamphlets, these merchants defended the principle that their trading activities buttressed the interest of the sovereign power, even when, to the consternation of the court, this required sending “treasure” (bullion) abroad. As the pamphleteers explained, treasure used in this way became itself a commodity in foreign trade , in which, as the 17th-century merchant Thomas Mun wrote, “we must ever observe this rule; to sell more to strangers than we consume of theirs in value.”

For all its trading mentality, mercantilism was only partially a market-coordinated system. Adam Smith complained bitterly about the government monopolies that granted exclusive trading rights to groups such as the East India or the Turkey companies, and modern commentators have emphasized the degree to which mercantilist economies relied on regulated, not free, prices and wages. The economic society that Smith described in The Wealth of Nations in 1776 is much closer to modern society, although it differs in many respects, as shall be seen. This 18th-century stage is called “ commercial capitalism,” although it should be noted that the word capitalism itself does not actually appear in the pages of Smith’s book.

Smith’s society is nonetheless recognizable as capitalist precisely because of the prominence of those elements that had been absent in its mercantilist form. For example, with few exceptions, the production and distribution of all goods and services were entrusted to market forces rather than to the rules and regulations that had abounded a century earlier. The level of wages was likewise mainly determined by the interplay of the supply of, and the demand for, labour—not by the rulings of local magistrates. A company’s earnings were exposed to competition rather than protected by government monopoly .

Perhaps of greater importance in perceiving Smith’s world as capitalist as well as market-oriented is its clear division of society into an economic realm and a political realm. The role of government had been gradually narrowed until Smith could describe its duties as consisting of only three functions: (1) the provision of national defense, (2) the protection of each member of society from the injustice or oppression of any other, and (3) the erection and maintenance of those public works and public institutions (including education) that would not repay the expense of any private enterpriser, although they might “do much more than repay it” to society as a whole. And if the role of government in daily life had been delimited, that of commerce had been expanded. The accumulation of capital had come to be recognized as the driving engine of the system. The expansion of “capitals”—Smith’s term for firms—was the determining power by which the market system was launched on its historic course.

Thus, The Wealth of Nations offered the first precise description of both the dynamics and the coordinative processes of capitalism. The latter were entrusted to the market mechanism—which is to say, to the universal drive for material betterment, curbed and contained by the necessary condition of competition. Smith’s great perception was that the combination of this drive and counterforce would direct productive activity toward those goods and services for which the public had the means and desire to pay while forcing producers to satisfy those wants at prices that yielded no more than normal profits. Later economists would devote a great deal of attention to the question of whether competition in fact adequately constrains the workings of the acquisitive drive and whether a market system might not display cycles and crises unmentioned in The Wealth of Nations . These were questions unknown to Smith, because the institutions that would produce them, above all the development of large-scale industry, lay in the future. Given these historical realities, one can only admire Smith’s perception of the market as a means of solving the economic problem.

Smith also saw that the competitive search for capital accumulation would impart a distinctive tendency to a society that harnessed its motive force. He pointed out that the most obvious way for a manufacturer to gain wealth was to expand his enterprise by hiring additional workers. As firms expanded their individual operations , manufacturers found that they could subdivide complex tasks into simpler ones and could then speed along these simpler tasks by providing their operatives with machinery. Thus, the expansion of firms made possible an ever-finer division of labour , and the finer division of labour, in turn, improved profits by lowering the costs of production and thereby encouraging the further enlargement of the firms. In this way, the incentives of the market system gave rise to the augmentation of the wealth of the nation itself, endowing market society with its all-important historical momentum and at the same time making room for the upward striving of its members.

One final attribute of the emerging system must be noted. This is the tearing apart of the formerly seamless tapestry of social coordination. Under capitalism two realms of authority existed where there had formerly been only one—a realm of political governance for such purposes as war or law and order and a realm of economic governance over the processes of production and distribution. Each realm was largely shielded from the reach of the other. The capitalists who dominated the market system were not automatically entitled to governing power, and the members of government were not entrusted with decisions as to what goods should be produced or how social rewards should be distributed. This new dual structure brought with it two consequences of immense importance. The first was a limitation of political power that proved of very great importance in establishing democratic forms of government. The second, closer to the present theme, was the need for a new kind of analysis intended to clarify the workings of this new semi-independent realm within the larger social order. As a result, the emergence of capitalism gave rise to the discipline of economics .

From commercial to industrial capitalism

Commercial capitalism proved to be only transitional. The succeeding form would be distinguished by the pervasive mechanization and industrialization of its productive processes, changes that introduced new dynamic tendencies into the economic system while significantly transforming the social and physical landscape.

The transformative agency was already present in Smith’s day, observable in a few coal mines where steam-driven engines invented by Thomas Newcomen pumped water out of the pits. The diffusion and penetration of such machinery-driven processes of production during the first quarter of the 19th century has been traditionally called “the” Industrial Revolution , although historians today stress the long germination of the revolution and the many phases through which it passed. There is no doubt, however, that a remarkable confluence of advances in agriculture , cotton spinning and weaving , iron manufacture, and machine-tool design and the harnessing of mechanical power began to alter the character of capitalism profoundly in the last years of the 18th century and the first decades of the 19th.

The alterations did not affect the driving motive of the system or its reliance on market forces as its coordinative principles. Their effect was rather on the cultural complexion of the society that contained these new technologies and on the economic outcome of the processes of competition and capital accumulation. This aspect of industrialization was most immediately apparent in the advent of the factory as the archetypal locus of production. In Smith’s time the individual enterprise was still small—the opening pages of The Wealth of Nations describe the effects of the division of labour in a 10-man pin factory—but by the early 19th century the increasing mechanization of labour , coupled with the application of waterpower and steam power , had raised the size of the workforce in an ordinary textile mill to several hundreds; by mid-century in the steel mills it was up to several thousands, and by the end of the century in the railways it was in the tens of thousands.

The increase in the scale of employment brought a marked change in the character of work itself. In Smith’s day the social distance between employer and labourer was still sufficiently small that the very word manufacturer implied an occupation (a mechanic) as well as an ownership position. However, early in the 19th century William Blake referred to factories as “dark Satanic mills” in his epic poem Jerusalem , and by the 1830s a great gulf had opened between the manufacturers, who were now a propertied business class, and the men, women, and children who tended machinery and laboured in factories for 10- and 12-hour stints. It was from the spectacle of mill labour, described in unsparing detail by the inspectors authorized by the first Factory Act of 1802, that Marx drew much of the indignation that animated his analysis of capitalism. More important, it was from this same factory setting, and from the urban squalor that industrialization also brought, that capitalism derived much of the social consciousness—sometimes revolutionary, sometimes reformist—that was to play so large a part in its subsequent political life. Works such as Charles Dickens ’s Hard Times (1854) depicted the factory system’s inhumanity and the underlying economic doctrines that supposedly justified it. While these works brought attention to the social problems stemming from industrialization, they also tended to discount the significant improvements in the overall standard of living (as measured by the increases in life expectancy and material comforts) that accompanied modernization . Country life of just a generation earlier had been no less cruel, and in some respects it was more inhuman than the factory system being criticized. Those critics who failed to compare the era of industrialization with the one that immediately preceded it also failed to account for the social and economic progress that had touched the lives of ordinary people.

The degradation of the physical and social landscape was the aspect of industrialization that first attracted attention, but it was its slower-acting impact on economic growth that was ultimately to be judged its most significant effect. A single statistic may dramatize this process. Between 1788 and 1839 the output of pig iron in Britain rose from 68,000 to 1,347,000 tons. To fully grasp the significance of this 20-fold increase, one has to consider the proliferation of iron pumps, iron machine tools, iron pipes, iron rails, and iron beams that it made possible; these iron implements, in turn, contributed to faster and more dependable production systems. This was the means by which the first Industrial Revolution promoted economic growth, not immediately but with gathering momentum. Thirty years later this effect would be repeated with even more spectacular results when the Bessemer converter ushered in the age of steel rails, ships, machines, girders, wires, pipes, and containers.

The most important consequence of the industrialization of capitalism was therefore its powerful effect on enhancing what Marx called “the forces of production”—the source of what is now called the standard of living . The Swiss economic demographer Paul Bairoch calculated that gross national product (GNP) per capita in the developed countries rose from $180 in the 1750s (in dollars of 1960 purchasing power) to $780 in the 1930s and then to $3,000 in the 1980s, whereas the per capita income of the less-developed countries remained unchanged at about $180–$190 from 1750 to 1930 and thereafter rose only to $410 in 1980. (This seemingly persistent gap between the richest and the poorest countries, which contradicts the predictions of the standard theory of economic growth, has increasingly occupied the attention of contemporary economists. Although the question is answered in part by explaining that the rich countries have experienced industrialization and the poor ones have not, the question remains why some have experienced industrialization and others have not.)

The development of industrialization was accompanied by periodic instability in the 18th and 19th centuries. Not surprisingly, then, one side effect of industrialization was the effort to minimize or prevent economic shocks by linking firms together into cartels or trusts or simply into giant integrated enterprises. Although these efforts dampened the repercussions of individual miscalculations, they were insufficient to guard against the effects of speculative panics or commercial convulsions. By the end of the 19th century, economic depressions had become a worrisome and recurrent problem, and the Great Depression of the 1930s rocked the entire capitalist world. During that debacle, GNP in the United States fell by almost 50 percent, business investment fell by 94 percent, and unemployment rose from 3.2 to nearly 25 percent of the civilian labour force. Economists have long debated the causes of the extraordinary increase in economic instability from 1830 to 1930. Some point to the impact of growth in the scale of production evidenced by the shift from small pin factories to giant enterprises. Others emphasize the role of miscalculations and mismatches in production. And still other explanations range from the inherent instability of capitalist production (particularly for large-scale enterprises) to the failure of government policy (especially with regard to the monetary system ).

From industrial to state capitalism

The perceived problem of inherent instability takes on further importance insofar as it is a principal cause of the next structural phase of the system. The new phase is often described as state capitalism because its outstanding feature is the enlargement in size and functions of the public realm. In 1929, for example, total U.S. government expenditures—federal, state, and local—came to less than one-tenth of GNP; from the 1970s they amounted to roughly one-third. This increase is observable in all major capitalist nations, many of which have reached considerably higher ratios of government disbursements to GNP than the United States.

At the same time, the function of government changed as decisively as its size. Already by the last quarter of the 19th century, the emergence of great industrial trusts had provoked legislation in the United States (although not in Europe) to curb the monopolistic tendencies of industrialization. Apart from these antitrust laws and the regulation of a few industries of special public concern, however, the functions of the federal government were not significantly broadened from Smith’s vision. Prior to the Great Depression, for example, the great bulk of federal outlays went for defense and international relations , for general administrative expense and interest on the debt , and for the post office .

The Great Depression radically altered this limited view of government in the United States, as it had earlier begun to widen it in Europe. The provision of old-age pensions and relief for the hungry, poor, and unemployed were all policies inaugurated by the administration of Pres. Franklin D. Roosevelt , following the example of similar enlargements of government functions in Britain, France, and Germany. From the 1970s onward, such new kinds of federal spending—under the designation of social security , health, education, and welfare programs —grew to be 20 to 50 percent larger than the traditional categories of federal spending.

Thus, one very important element in the advent of a new stage of capitalism was the emergence of a large public sector expected to serve as a guarantor of public economic well-being, a function that would never have occurred to Smith. A second and equally important departure was the new assumption that governments themselves were responsible for the general course of economic conditions. This was a change of policy orientation that also emerged from the challenge of the Great Depression. Once regarded as a matter beyond remedy, the general level of national income came to be seen by the end of the 1930s as the responsibility of government, although the measures taken to improve conditions were on the whole timid, often wrongheaded (such as highly protectionist trade policies), and only modestly successful. Nonetheless, the appearance in that decade of a new economic accountability for government constitutes in itself sufficient reason to describe capitalism today in terms that distinguish it from its industrial, but largely unguided, past.

There is little doubt that capitalism will continue to undergo still further structural alterations. Technological advances are rapidly reducing to near insignificance the once-formidable barriers and opportunities of economic geography. Among the startling consequences of this technological leveling of the world have been the large displacements of high-tech manufacturing from Europe and North America to the low-wage regions of Southwest Asia , Latin America , and Africa. Another change has been the unprecedented growth of international finance to the point that, by the beginning of the 21st century, the total value of transactions in foreign exchange was estimated to be at least 20 times that of all foreign movements of goods and services. This boundary-blind internationalization of finance, combined with the boundary-defying ability of large corporations to locate their operations in low-wage countries, poses a challenge to the traditional economic sovereignty of nations, a challenge arising from the new capabilities of capital itself.

A third change again involves the international economy, this time through the creation of new institutions for the management of international economic trade. A number of capitalist nations have met the challenges of the fast-growing international economy by joining the energies of the private sector (including organized labour ) to the financial and negotiating powers of the state. This “corporatist” approach, most clearly evident in the organization of the Japanese economy, was viewed with great promise in the 1980s but in the 1990s was found to be severely vulnerable to opportunistic behaviour by individuals in both the public and the private sectors. Thus, at the onset of the 21st century, the consensus on the economic role of government in capitalism shifted back from the social democratic interventionism of the Keynesian system and the managed market economies of the “Asian tigers” (countries such as Hong Kong , Singapore, Malaysia, and South Korea that experienced rapid growth in the late 20th century) to the more noninterventionist model of Adam Smith and the classical economists.

It is not necessary, however, to venture risky predictions concerning economic policy . Rather, it seems more useful to posit two generalizations. The first emphasizes that capitalism in all its variations continues to be distinguished from other economic systems by the priority accorded to the drive for wealth and the centrality of the competitive mechanism that channels this drive toward those ends that the market rewards. The spirit of enterprise, fueled by the acquisitive culture of the market, is the source of the dynamism of capitalism. The second generalization is that this driving force and constraining mechanism appear to be compatible with a wide variety of institutional settings, including substantial variations in the relationships between the private and public sectors. The form of capitalism taken also differs between nations, because the practice of it is embedded within cultures; even the forces of globalization and the threat of homogenization have proved to be more myth than reality. Markets cater to national culture as much as national culture mutates to conform to the discipline of profit and loss. It is to this very adaptability that capitalism appears to owe its continued vitality.

Market Economy

Overview and definition of a market economy

What is a Market Economy?

A market economy is defined as a system where the production of goods and services are set according to the changing desires and abilities of the market players. It allows the market to operate freely in accordance with the law of supply and demand, set by individuals and corporations, as opposed to governments.

The principle of market economy dictates that producers and sellers of goods and services will offer them at the highest possible price that consumers are willing to pay for goods or services. When the level of supply meets the level of demand, a natural economic equilibrium is achieved.

The opposite of a market economy is a command economy, which is centrally controlled by the government.

Characteristics of a Market Economy

• Individuals are allowed to profit from private ownership of business and property. Ownership rights are not only for the government, as in a command economy.
• Market players are free to produce, sell, and purchase as they please, subject to government regulations.
• The market is motivated by individuals trying to sell their offerings to the highest bidder, while simultaneously attempting to pay the least for goods and services that they need (profit motive).
• Competition is present among producers, which keeps prices fair and ensures efficient production and supply.
• Players enjoy equal access to relevant information on which to base their decisions.
• The government plays a limited role in a market economy but performs a regulatory function to ensure fair play and avoid the creation of monopolies .

Some countries with a market economy include the U.S., Canada, the U.K., and Denmark.

Advantages of a Market Economy

• Increased efficiency in the production of goods and services due to business competition
• Encourages innovation, which keeps the market evolving
• People work harder to maintain their livelihood and prevent losing their jobs
• Growing markets attract foreign investors
• Wider variety of consumer goods available
• Encourages entrepreneurship and new ventures
• Decreased state bureaucracy, as some public sector activities can be taken over by private entities

Disadvantages of a Market Economy

• Inevitable periods of economic crisis due to the usual business cycle ebb and flow
• Possibly higher unemployment levels as compared to command economies
• Wider economic and social gaps
• Possible exploitation of labor
• Basic necessities may be harder to provide, as they are affected by demand and supply
• Profiteering is favored over social welfare

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Microeconomics

Course: microeconomics   >   unit 1.

• Property rights in a market system
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Lesson overview: economic systems, the role of incentives, and the circular flow model

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3.2.1: Introducing the Market System

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Defining a Market System

A market system is a way to match buyers and sellers.

Learning objectives

Identify the characteristics of a market system

In an economy, a market system is any systematic process that enables many market players to bid and ask. In other words, a market system is a place (virtual or physical) that facilitates the matching of buyers and sellers. Many markets exist, and each can be defined based on a number of characteristics, such as what is being exchanged in the market, the regulations, who is allowed to participate, and how transactions occur.

One defining component of markets is the medium of exchange, or the price. In most American markets, the medium of exchange is dollars. Both buyers and sellers look at the price to determine whether or not they want to trade. A seller has a certain minimum price at which s/he is willing to sell, though s/he would happily accept more. Likewise, a buyer has a certain maximum price at which s/he is willing to buy, though s/he would happily pay less. If the minimum the seller would accept is less than the maximum a buyer would pay, a transaction can occur. Markets help such buyers and sellers meet to trade.

In market systems, prices are discoverable; both buyers and sellers are capable of finding out the current price at which a transaction could occur. Publishing current prices is a key component with a market system. The chosen prices impact the immediate group of buyers and sellers, but also may impact long term supply and demand decisions within the market.

There are many examples of market systems. Perhaps the most famous is the stock market in which buyers and sellers trade stocks. The prices at which those sales occur is recorded, and is the basis for the stock price you may have seen in the newspaper or on TV. There are markets for many types of products other than stocks: the global oil market, your local farmers’ market, and eBay are all forms of markets with their own defining characteristics.

NASDAQ Stock Market Display : The NASDAQ is a stock market where buyers and sellers of stocks can meet and trade.

Another important component of market systems is that there is competition, which serves as the main regulatory mechanism. Based on the level of competition in a market system, economists have identified a number of different types of structures, such as monopoly, oligopoly, and perfect competition. We will go into more detail on different market structures later in the book.

Gains from Markets

Gains in a market are referred to as total welfare or economic surplus.

Explain how to calculate total welfare

Gains within a market are referred to as total welfare or economic surplus. Within total welfare, economists look at consumer surplus and producer surplus. A surplus is defined as the excess of a good or service when the quantity supplied exceeds the quantity demanded; this occurs when the price is above the equilibrium price.

Economic Surpluses : The total welfare (or economic surplus) is the sum of the consumer surplus and the producer surplus.

Consumer surplus is the monetary gain that consumers receive when they purchase a good for less than the highest price they are willing to pay. For example, a customer is willing to pay $50 for a new pair of running shoes. They are able to purchase the pair for $35 and consumer surplus is $15.

Producer surplus is the amount that producers benefit by selling a good at a market price that is higher than the least that they would be willing to sell it for. An example would be a manufacturer that makes jeans. The lowest price the producer is willing to sell a pair of jeans for is $40, but the jeans actually sell for $50. The producer surplus is $10.

In order to calculate the total welfare, the supply and demand of the good must be used to determine the economic gain. On a demand and supply curve graph, the consumer surplus is located under the demand curve and above a horizontal line that shows the actual price of a good (equilibrium price).

When the supply of a good increases, the price falls which increases consumer surplus. When the demand for a good increases, the price increases and the supply decreases resulting in producer surplus. When a good is in high demand, consumers are willing to pay more in order to obtain the good.

Production Possibility Frontier

A production-possibility frontier (PPF) graphs the combinations for the production of two commodities with which the same amounts are used.

Explain the benefits of trade and exchange using the production possibilities frontier (PPF)

Within a market system, economists use the production possibility frontier (PPF) to graph the combinations of the amounts of two commodities that can be produced using the same amount of each factor of production. A PPF graph chooses specific input quantities. As a result, it shows the maximum production level for one commodity for any production level of the other commodity. PPF is used to define production efficiency.

A common PPF : A common PPF where there is an increase in opportunity cost.

Within a PPF graph, the use of a curve or line acts as a benchmark for measuring efficiency. If a point on the graph is above the curve it indicates efficiency, while a point below the curve signifies inefficiency. For further analysis, additional information is always supplied with a PPF including the period of time taken for the observation, production technologies, and the amounts of inputs that were available.

Economists can use a PPF to illustrate a number of economic concepts including scarcity, opportunity cost, productive efficiency, allocative efficiency, and economies of scale.

When an economy is operating on the PPF curve it is efficient. It is not possible to produce more of one good without decreasing the amount produced for the other good. Likewise, if the economy is operating below the PPF curve, it is inefficient. In this case, the economy can reallocate resources and produce more of both the goods.

The PPF graph shows how resources must be shared among goods during the production process. The points of the graph show the trade -off that takes place between two goods. For example, if more of Good A needs to be produced, the amount of resources in use by Good B must be reduced and transferred to Good A. The sacrifice in production of Good B is called opportunity cost. When graphing PPF there are three types: the common, the straight line, and the inverted PPF. All three of the PPF graphs are directly influenced by the opportunity cost.

An inverted PPF : An inverted PPF where the opportunity cost is decreasing.

A straight line PPF : A straight line PPF where the opportunity cost is constant.

The slope of the PPF shows the rate at which the production of one good can be transferred to another. The slope is called the marginal rate of transformation (MRT).

Within an economy, if the capacity to produce both goods increases, the result is economic growth. Factors that influence economic capacity include technology, an increase in the supply of factors of production, and production interactions such as trade and exchange. When any of these factors are used it allows for an increase in capacity so that the production of neither good has to be sacrificed.

PPF graphs help economists study the current state of production as well as possible production scenarios. The output of the economy is impacted by many factors. When production can be graphed and monitored it allows adjustments to be made to work towards attaining economic growth and stability.

The Circular Flow Model

In economics, a circular flow model is a diagram that is used to represent the monetary transactions in an economy.

State the function of the circular flow diagram and the production possibilities frontier

In economics, a circular flow model is a diagram that is used to represent the monetary transactions in an economy. There are two flows present within the model including flows of physical things (goods or labor) and flows of money (what pays for physical things). A circular flow model depicts the inner workings of a market system and specific portions of the economy.

The basic circular flow model consists of two sectors that determine income, expenditure, and output. A state of equilibrium is reached when there is no tendency for the levels of income (YY), expenditure (EE), and output (OO) to change (Y=E=OY=E=O). This equation means that the expenditure of buyers (households) becomes income for sellers ( firms ). The firms spend the income on factors of production, which “transfers” the income to the factor owners. The factor owners spend the income on goods which leads to the circular flow of payments.

Circular flow of goods income : The circular flow model shows the flow of payments between households and firms.

The circular flow of payments is important within an economy because it 1) measures the national income, 2) provides knowledge of interdependence, 3) illustrates the unending nature of economic activities, and 4) shows injections and leakages.

The circular flow of income follows a specific pattern: Production → Income → Expenditure → Production. This circular flow is ongoing between households and firms.

The circular flow of income can also be analyzed using the production possibility frontier (PPF). The PPF is a graph that shows the various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production. The graph shows the maximum possible production level of one commodity for any production level of the other, based on the state of technology. The PPF defines production efficiency. A point of the frontier line indicates the efficient use of available inputs, while a point beneath the curve shows inefficiency. A PPF graphs shows opportunity cost, actual output, potential output, and economic growth.

Production Possibilities Frontier Curve : The graph illustrates a typical production possibilities frontier curve. When a market is operating on the PPF it is said to be efficient.

• Publishing current prices is a key component with a market system.
• Competition is the primary regulatory mechanism in a market system.
• Economists recognize a number of different structures of market systems based on characteristics such as the level of competition.
• Within total welfare, economists look at consumer surplus and producer surplus.
• Consumer surplus is the monetary gain that consumers receive when they purchase a good for less than the highest price they are willing to pay.
• Producer surplus is the amount that producers benefit by selling a good at a market price that is higher than the least that they would be willing to sell it for.
• In order to calculate the total welfare, the supply and demand of the good must be used to determine the economic gain.
• When the supply of a good increases, the price falls which increases consumer surplus. When the demand for a good increases, the price increases and the supply decreases resulting in producer surplus.
• A PPF graph shows the maximum production level for one commodity for any production level of the other commodity.
• If a point on the graph is above the curve it indicates efficiency, while a point below the curve signifies inefficiency.
• The PPF graph shows how resources must be shared among goods during the production process.
• Within an economy, if the capacity to produce both goods increases which results in economic growth.
• There are two flows present within the model including flows of physical things (goods or labor) and flows of money (what pays for physical things).
• The circular flow of income follows a specific pattern: Production → Income → Expenditure → Production.
• The production possibility frontier can be used to illustrate the circular flow model.
• Economists use data, statistics, and natural experiments in order to make economic “laws” that explain general patterns.
• price : The quantity of payment or compensation given by one party to another in return for goods or services.
• welfare : Health, safety, happiness and prosperity; well-being in any respect.
• commodity : Raw materials, agricultural and other primary products as objects of large-scale trading in specialized exchanges.
• marginal : Of, relating to, or located at or near a margin or edge; also figurative usages of location and margin (edge).
• expenditure : Act of expending or paying out.
• Factors of production : In economics, factors of production are inputs. They may also refer specifically to the primary factors, which are stocks including land, labor, and capital goods applied to production.

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What Is a Market Economy?

How a Market Economy Works

Characteristics of a market economy, alternatives to a market economy, pros and cons of a market economy, frequently asked questions (faqs).

The Balance

A market economy is an economic system in which individuals, rather than the state, own most of the resources. This includes land, labor, and capital. In a market economy, individuals control the use and price of these resources through voluntary decisions made in the marketplace.

Key Takeaways

• A market economy is an economic system in which individuals, rather than the state, own most of the resources.
• Resources in a market economy include land, labor, and capital.
• In a command economy, a central government or single ruler decides how many goods should be produced and services provided, and sets their prices.
• Most countries, including the U.S., have economies with elements of both market and command economies.
• Supporters of market economies argue that these economies have led to unprecedented development and growth.
• Critics say market economies can disenfranchise vulnerable groups and lead to inequality

In a market economy, private individuals, companies, and corporations own most of the resources. Individuals make decisions that contribute to supply and demand, which set prices and direct the production and use of goods and services.

The concept of private property is central to the market economy, because it gives owners the right to sell their goods. Competition is also an important factor, because it affects supply and demand.

In contrast to a market economy, in a command economy, a central government (or even a single ruler) decides how many goods should be produced and services provided, and sets their prices. Market economies are not controlled by a central authority such as a government, and are instead based on voluntary exchange.

Market economies are a type of capitalism —an economic system in which private entities or people own the means of production. Conversely, command economies are tied to socialism and communism, where the collective group owns the means of production.

Examples of a Market Economy

Today, very few national economies are “pure” market economies or command economies. Most countries, including the U.S., have a mixed economy with elements of both market and command economies.

In the U.S., some people believe the market economy is largely self-regulating. Others argue that the government should take a more active role in regulating companies and markets.

Today, some sectors of the U.S. economy are highly regulated and directed by the government, and others operate with less government intervention. Because of this, the distinction between whether a country has a command economy or a market economy is less clear-cut.

Economists today distinguish between many different types of market economies, based on how much a government intervenes in markets. In liberal market economies, for example, the competitive market is prevalent, as seen in the U.S. and the U.K. Coordinated market economies, on the other hand, exchange private information through non–market institutions such as unions and business associations. Germany and Japan use this model.

A well-functioning market economy relies on a number of economic institutions, rights, freedoms, and conventions.

Private Ownership

In a market economy, most goods and services are privately owned. Owners can profit by selling or leasing property, products, or services.

Freedom of Choice

Owners are free to produce, sell, and purchase goods and services in a competitive market. They do have two factors that are somewhat outside of their control. First, a buyer must be willing to pay the price they set for their goods or services. Second, the amount of capital they have is determined by the costs to produce and sell their goods and the price they can sell them.

Motive of Self-Interest

Self-interest is one of the primary factors behind a successful market economy. Most businesses have been created for the best interests of the people that started them. A market economy provides opportunity, gives people a chance to work for themselves, and lets them try to earn a living in a way that they want to.

In a market economy, sellers aim to sell to the highest bidder while negotiating the lowest price for their purchases. Although their motives are for their own self-interest, this benefits the overall economy over the long run. It creates a system that sets prices that reflect an accurate picture of supply and demand at any given moment.

Competition

The force of competitive pressure keeps prices low. It also ensures that society provides goods and services more efficiently.

As soon as demand increases for a particular item, prices rise thanks to the law of demand . Competitors see they can enhance their profit by producing the same item, adding to supply. That lowers prices to a level where only the best competitors remain.

Competitive pressure also applies to workers and consumers. Employees vie with one another for the highest-paying jobs, and buyers compete for the best product at the lowest price.

A System of Markets and Prices

A market economy relies on an efficient market in which to sell goods and services. A market is said to be efficient when all buyers and sellers have equal access to the same information about prices, supply, and demand. As a result, price changes are pure reflections of the laws of supply and demand.

Limited Government

Even in a market economy, the government plays a role. It ensures that the markets are open, working, stable, fair, and safe. For example, many governments create regulatory agencies to ensure that products are safe for use and consumption, and that businesses are not taking advantage of consumers.

Government regulations can also work to ensure that everyone has equal access to the markets and information, and that it is free of manipulation. The government can penalize companies that command too dominant a share in the market, known as a monopoly .

Although most countries today have some form of market economy, this hasn’t always been the case, and there are a number of alternatives to this economic model. The economies of medieval Europe were feudal, for example, and anthropologists have discovered many different economic models among indigenous groups.

For most of the last century, however, market economies have been understood in contrast to command economies. Cuba, North Korea, and the former Soviet Union all have or had command economies. China maintained a command economy until 1978, when it began its transition to a mixed economy that blends communist and capitalist elements.

No economy today, except at the smallest scale, is a “pure” market economy. Almost all markets are regulated to some degree. This is because free markets can flourish only when governments protect individuals’ rights and support markets with proper infrastructure.

A related concern is inequality. Recent studies have found that in contemporary market economies, the rate of return on investment frequently outstrips average growth across a society. Left unchecked, this phenomenon means the wealth held by owners of capital increases far more rapidly than other kinds of earnings (wages, for example). This process creates then deepens inequality.

Consumers and businesses drive supply and demand

Competition encourages efficiency

Innovation is rewarded with profits.

Businesses invest in one another

Competition can be unfair and create inefficiency

Not everyone can realize their full potential

Can create and deepen inequality

Difficult to coordinate society-wide responses to events

Pros Explained

• Consumers and businesses drive supply and demand : Since a market economy allows the free interplay of supply and demand, it ensures that the most desired goods and services are produced. Consumers are willing to pay the highest price for the things they want the most. Businesses will aim to provide products and services that return a profit.
• Competition encourages efficiency : Goods and services are produced efficiently. The most productive companies will earn more than less productive ones.
• Innovation is rewarded with profits : Creative new products will meet the needs of consumers in better ways than existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable.
• Businesses invest in one another : Successful businesses invest in other companies, which can help them succeed. That can lead to increased quality of production.

Cons Explained

• Competition can be unfair and create inefficiency : The key mechanism of a market economy is competition. As a result, there is no inherent system to care for those at a competitive disadvantage. That includes older adults, children, and people with mental or physical disabilities that keep them from working.
• Not everyone can realize their full potential : The human resources of society may not be optimized. For example, children in lower-income families often work lower-income jobs to add to the family resources. If a market economy were concerned about progress rather than self-interest, these children might be afforded more opportunities for education and career choice.
• Can create and deepen inequality : Society reflects the values of the winners in the market economy. A market economy may produce private jets for some people, while others have no food or homes. A society based on a pure market economy must decide whether and how it should care for the vulnerable.

What are the characteristics of a free market economy?

The main characteristic of a market economy is that individuals own most of the land, labor, and capital. In other economic structures, the government or rulers own the resources.

What countries have a market economy?

Most countries have mixed economies with elements of a market economy. The United States, The United Kingdom, Japan, and Germany all are examples that have elements of a market economy. Singapore is the country that is the closest to having strictly a market economy.

Federal Reserve Bank of St. Louis. “ Role of Self-Interest and Competition in a Market Economy .”

International Monetary Fund. “ What Is Capitalism? ”

International Institute for Environment and Development. “ Here’s Why Indigenous Economics Is Key to Saving Nature .”

Congressional Research Service. “ China’s Economic Rise .” Page 4.