A market economy is a system where the decisions concerning production, investment and distribution are controlled by the forces of demand and supply. This type of economy is characterized by a centralization of economic activity that is not driven by a competitive analysis of the costs and benefits of doing business. Unlike a centrally planned economy in which the system of controls is internally consistent, the system of economics based on market principles cannot be forced to converge towards one form of value or the other by any external force. It can only evolve by allowing different institutions to decide for themselves based on their own valuation of the market situations.
The underlying idea of a market economy can be illustrated using an example from the world of business. In a market economy, competition is the driving force behind changes in production processes and prices. The process of establishing prices is called “Pricing”. The process of determining whether a particular price is fair may be called “Pricing mechanisms”. In such a system of pricing, individuals and private property owners have the ability to control the supply of certain goods and services and the conditions under which they are sold.
Under a market economy, a buyer decides what price he will pay for a particular good or service and then offers that price to the seller of the goods or services. If the seller wants to match the highest price possible to his customers, he must adjust his prices or introduce new goods and services. In socialism, the state regulates the production, distribution, and price levels and tries to maintain a level price so that all residents of the state receive a similar share of the products or services produced and distributed. In this way, the theory of socialism assumes that people participate in the production of the goods and services.
Socialism attempts to maximize profits. An aspect of socialism that draws some sympathy from classical liberal thinkers is its focus on the creation of demand in a market economy. Classical liberal thinkers believe that markets work best when there is plenty of competition to drive up the prices of goods and services and drive down the costs of production. Since the state provides goods and services through taxation, it may not be possible for an individual to compete with other individuals or the state for profits. However, in a market economy, if everyone is bidding for a share of a good or service, then everyone gets a good or service at a fair price, thus increasing the incentive to produce more and provide more services at lower costs.
A command economy, on the other hand, attempts to limit market disturbances. In a command economy, the government attempts to stabilize or ensure normal market fluctuations. The concept of a command economy stems from monopoly, where the state controls the production of a certain good or service through a monopoly of that good or service. Monopolies can lead to economic problems because it can lead to increased production, decreased demand, and so on. Command economies also limit the ability of consumers to freely choose the supply of goods and services and the conditions under which those supplies are produced and sold.
An alternative to command economies exists in the form of freer markets. Free markets, unlike command economies, allow consumers to determine their own needs and demand for goods and services at a particular point in time. The difference between a free market and a market economy, however, lies in the fact that in a free market, demand and supply curves are normally in balance. In a market economy, however, the demand for particular goods and services increases because individuals have equal access to those goods and services.
The problems of a market economy arise when the distribution of goods and services in society is distorted. For instance, suppose that some people have access to very expensive goods while other people have little or no access to such goods. The problem could be solved in a market economy by increasing the number of consumers that have access to more expensive goods. However, if that same increase in supply of goods is made possible only by reducing the rate at which some individuals can access them, the problem will still persist. So, it is not true that the distribution of goods and services in society is determined by demand and supply curves. In a free market economy, the government would decide what level of prices should be attained so that all buyers have access to the goods and services they need.
There are problems with a market economy in that prices may be regulated by external forces and production may be controlled by a small group of producers. Those who control the distribution of goods and services also control the number of goods produced. If too few goods are produced, prices will be driven up. If too many goods are produced, the problem of overproduction may result in shortages of some basic goods. Thus, the goals of providing enough basic services and goods at reasonable prices to meet individual needs and desires and providing opportunities for growth within the economy are frustrated in a market economy.