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Adam Farren

Market economy refers to a system where the prices of goods and services are set by supply and demand. The value of information, goods, and services is determined through free trade. In 2008, free trade is often regulated by governments, resulting in a mixed economy rather than a pure free market system.

A market economy is the opposite of a command or centrally planned economy. In a command system, the government determines what goods are sold, how much of them, and what they will cost. This single actor is replaced by many in a market system, where the price of a good is determined by both the supply and demand for it.

Mixed Economies are More Common

Today, most markets are actually mixed economies, with governments placing varying amounts of regulation on the forces of supply and demand. There is significant debate among economists regarding the amount of government intervention considered optimal for efficient economic operations. This has been especially relevant during the 2008 Financial Crisis, as the U.S. government has stepped in aggressively to bail out investment banks and purchase souring Collateralized debt obligations.

Free Market vs. Capitalism

A market economy is not synonymous with capitalism; free markets can exist in communist systems (such as in China) and other systems that do not have capitalism's defining characteristics. In capitalism, labor is a commodity employed by corporations to earn profits and return shareholder value. A market economy simply means a free market or any system in which prices are not fixed but set by the inverse forces of supply, or quantity of goods, and demand, their consumption by individuals and institutions.

Prices are Set by Supply and Demand

According to the supply-demand model that, in a pure market economy, is the sole determinant of price, there is only one price level at which quantity demanded is in balance with the quantity supplied. This price is the point at which the supply and demand curves cross.

Consider a case in which quantity demanded is more than the quantity supplied (a shortage). In this situation, suppliers will raise the price of the goods available - which in turn lowers demand, since as price increases demand decreases - and the two curves will meet at the equilibrium price point.

The reverse is also true - when the price is higher than the quantity demanded, there is a surplus. In order to sell the extra goods, suppliers will lower the price, which in turn raises demand. The price is thus "set by the market" - prices constantly adjust to the equilibrium of the dueling forces of supply and demand.

The supply-demand model says that the price of a good is set when the quantity supplied equals the quantity demanded.