Characteristics of a Market Economy

In the last lesson, we defined the different economic systems that exist in today's world: command, traditional, market, and mixed. We highlighted the central role that consumers and producers play in a market economy and stressed the ability of individuals to make their own economic decisions. However, these are not the only important elements of a market economy. In today's lesson, we'll discuss the six main characteristics of market economies.

1. Private Ownership

One of the central elements of a market economy is the private ownership of resources. The government doesn't control the nation's resources—the people do. This creates an incentive for each citizen to use these resources as efficiently as possible. Moreover, people must weigh the value of using their resources now against the value of conserving them for the future.

The protection of private property has been a central element of the American economy since the country's inception. Indeed, two years before the Declaration of Independence declared our right to life, liberty, and the pursuit of happiness, the First Continental Congress said in the Declaration of Colonial Rights that we were entitled to the rights of life, liberty, and property. Private ownership of property was a key principle of the early United States and has been a vital component of America's economic success.

That the inhabitants of the English colonies in North-America, by the immutable laws of nature, the principles of the English constitution, and the several charters or compacts, have the following RIGHTS:

Resolved, N.C.D. 1. That they are entitled to life, liberty and property: and they have never ceded to any foreign power whatever, a right to dispose of either without their consent.

Declaration of Colonial Rights (1774)

Resolved, N.C.D. 1. That they are entitled to life, liberty and property: and they have never ceded to any foreign power whatever, a right to dispose of either without their consent.

Declaration of Colonial Rights (1774)

2. Competition

Competition among businesses is another important component of a market economy. This competition keeps prices low and increases the quality of goods and services. When there's no competition, companies can charge whatever they want for their products and get away with it, especially if they sell an essential item.

Take a second and think about what would happen if there was only one distributor of gasoline in the country. Instead of going to Exxon, Shell, Marathon, Chevron, or one of a hundred other gas station companies, you'd only be able to go to an Exxon station. With no competition, what would happen to the price of gas? Exxon would raise the price higher and higher. Consumers who needed to fill up their cars would have no alternative; they would have to pay whatever price Exxon charged. This is what makes a monopoly—one organization having complete control over one industry—so dangerous. When the natural competition of a market economy is disrupted, prices skyrocket and consumers suffer.

3. Supply-and-Demand Price System

In a market economy, the market—the sum total of all of the buyers and sellers in a specific area—decides how much everything costs. But how does the market "decide" prices? Prices are determined by two main factors:

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Supply: How much of a product is available
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Demand: How much of a product people want

These two factors have an inverse relationship. That means that as one goes up, the other goes down, and vice versa. If the supply of a particular product increases, then demand will decrease. If supply decreases, then demand will increase. We'll talk more about how the forces of supply and demand interact later in the course. At this point, it's just important to understand that in a market economy, it's these market forces of supply and demand that determine prices.

4. Consumer Sovereignty

In the last lesson, we introduced the idea that in a market economy, consumers control what goods and services are produced by casting "dollar votes." The idea that consumer desire determines what goods and services producers create is known as consumer sovereignty.

Consumer sovereignty is a key component of a market economy. The government doesn't tell producers what to produce (like in a command economy), and producers don't simply produce what they've always done in the past (like in a traditional economy). Instead, producers react to consumer desires and try to create products that best fulfill those desires. A producer could make the best product imaginable, but if there aren't any consumers who want that product, the producer will go out of business.

5. Profit Motive

Profit motive is likely the most controversial aspect of market economies; however, it's vital for producers to be rewarded for their efforts. When businesses have a proper incentive, they are much more likely to produce what consumers demand and to produce those products efficiently. By keeping costs down, they not only create more profit for themselves but also make the entire national economy more prosperous.

Starting new businesses and creating new products are both risky endeavors for the following reasons: they require a lot of investment, business owners have the potential to lose everything, and the success rate is very low. In fact, many more businesses fail than succeed. Without a worthwhile reward, no one would take the risks required to develop new products, and the economy would stagnate.

Of course, this isn't a controversial topic for no reason. Companies have proven that they will break rules and take dangerous risks just to earn a few extra dollars. Some of these are intentional crimes, but the pursuit of profit and efficiency can also lead to unintended consequences, such as pollution and environmental damage. We'll discuss these consequences more in the next lesson.

6. Limited Government

Finally, limited government is a staple of market economies. The government takes a mostly hands-off approach to the economy, letting competition and the market forces of supply and demand determine prices, allowing consumers to dictate what goods and services are produced, and permitting businesses to make a profit.

However, the government does play an important role as a referee. It protects consumers and workers, ensures companies don't wreck the environment, and safeguards personal property rights. It also makes sure that competition stays healthy by breaking up monopolies, enforcing antitrust laws, and preventing any single company from becoming too powerful.

Review of Key Terms

monopoly: one organization having complete control over one industry
market: the sum total of all of the buyers and sellers in a specific area
consumer sovereignty: the desires of consumers determine what goods and services producers create

All six of these elements are essential for a market economy to operate effectively. If one characteristic disappears, then it will affect the other characteristics, and a chain reaction will occur that eventually disrupts the entire economy. For example, if competition dies because a company achieves a monopoly, then it will disrupt the supply-and-demand price system. Or if the government tries to take the profit motive out of the economy, then consumer sovereignty will suffer because consumers will no longer be able to dictate production with their dollar votes.