A market economy is a system where the laws of supply and demand direct the production of goods and services. Supply includes natural resources, capital, and labor. Demand includes purchases by consumers, businesses, and the government.
Businesses sell their wares at the highest price consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills allow. Employers seek to get the best employees at the lowest possible price.
Capitalism requires a market economy to set prices and distribute goods and services. Socialism and communism need a planned economy to create a central plan that guides economic decisions. Market economies evolve from traditional economies. Most societies in the modern world have elements of all three types of economies. That makes them mixed economies.
Six Characteristics of a Market Economy
The following six characteristics define a market economy.
- Private Property. Most goods and services are privately-owned. The owners can make legally-binding contracts to buy, sell, or lease their property. In other words, their assets give them the right to profit from ownership. But U.S. law excludes some assets. Since 1865, you cannot legally buy and sell human beings. That includes you, your body, and your body parts.
- Freedom of Choice. Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two constraints. First is the price at which they are willing to buy or sell. Second is the amount of capital they have.
3. Motive of Self-Interest. Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. Although the reason is selfish, it benefits the economy over the long run. This auction system sets prices for goods and services that reflect their market value. It gives an accurate picture of supply and demand at any given moment.
4. Competition. The force of competitive pressure keeps prices low. It also ensures that society provides goods and services most 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 it, adding to supply. That lowers prices to a level where only the best competitors remain. This competitive pressure also applies to workers and consumers. Employees vie with each other for the highest-paying jobs. Buyers compete for the best product at the lowest price. There are three strategies that work to maintain a competitive advantage.
5. System of Markets and Prices. A market economy relies on an efficient market in which to sell goods and services. That’s where all buyers and sellers have equal access to the same information. Price changes are pure reflections of the laws of supply and demand. There are five determinants of demand.
6. Limited Government. The role of government is to ensure that the markets are open and working. For example, it is in charge of national defense to protect the markets. It also makes sure that everyone has equal access to the markets. The government penalizes monopolies that restrict competition. It makes sure no one is manipulating the markets and that everyone has equal access to information.
Four Advantages of a Market Economy
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 only create those things that return a profit.
Second, goods and services are produced in the most efficient way possible. The most productive companies will earn more than less productive ones.
Third, it rewards innovation. Creative new products will meet the needs of consumers in better ways that existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable. This illustrates why Silicon Valley is America’s innovative advantage.
Fourth, the most successful businesses invest in other top-notch companies. That gives them a leg up and leads to increased quality of production.
The Disadvantages of a Market Economy
The key mechanism of a market economy is competition. As a result, it has no system to care for those who are at an inherent competitive disadvantage. That includes the elderly, children, and people with mental or physical disabilities.
Second, the caretakers of those people are also at a disadvantage. Their energies and skills go toward caretaking, not competing. Many of these people might become contributors to the economy’s overall comparative advantage if they weren’t caretakers.
That leads to the third disadvantage. The human resources of the society may not be optimized. For example, a child who might otherwise discover the cure for cancer might instead work at McDonald’s to support her low-income family.
Fourth, the society reflects the values of the winners in the market economy. A market economy may produce private jets for some while others starve and are homeless. A society based on a pure market economy must decide whether it’s in its larger self-interest to care for the vulnerable.
If it decides it is, the society will grant the government a significant role in redistributing resources. As such, there are so many mixed economies. Most so-called market economies are mixed economies.
The Preamble of the Constitution includes a goal to “promote the general welfare.” The government could take a larger role than what a market economy prescribes. This led to many social safety programs, such as Social Security, food stamps, and Medicare.
Five Traits of a Planned Economy
A Planned economy is where a central government makes all economic decisions. Either the government or a collective owns the land and the means of production. It doesn’t rely on the laws of supply and demand that operate in a market economy. A Planned economy also ignores the customs that guide a traditional economy. In recent years, many centrally-planned economies began adding aspects of the market economy. The resultant mixed economy better achieves their goals.
Five Characteristics of a Planned Economy
You can identify a modern centrally planned economy by the following five characteristics.
- The government creates a central economic plan. The five-year plan sets economic and societal goals for every sector and region of the country. Shorter-term plans convert the goals into actionable objectives.
- The government allocates all resources according to the central plan. It tries to use the nation’s capital, labor and natural resources in the most efficient way possible. It promises to use each person’s skills and abilities to their highest capacity. It seeks to eliminate unemployment.
- The central plan sets the priorities for the production of all goods and services. These include quotas and price controls. Its goal is to supply enough food, housing, and other basics to meet the needs of everyone in the country. It also sets national priorities. These include mobilizing for war or generating robust economic growth.
4. The government owns monopoly businesses. These are in industries deemed essential to the goals of the economy. That usually includes finance, utilities, and automotive. There is no domestic competition in these sectors.
5. The government creates laws, regulations, and directives to enforce the central plan. Businesses follow the plan’s production and hiring targets. They can’t respond on their own to free market forces.
A Planned economy has a few advantages, although they come with a few important disadvantages as well.
- Can manipulate large amounts of resources for large projects without lawsuits or environmental regulatory issues.
- An entire society can be transformed to conform to the government’s vision, from nationalizing companies to placing workers in new jobs after a governmental skill assessment.
- Rapid change can completely ignore society’s needs, forcing the development of a black market and other coping strategies.
- Goods production is not always matched to demand, and poor planning often leads to rationing.
- Innovation is discouraged and leaders are rewarded for following orders rather than taking risks.
Planned economies can quickly mobilize economic resources on a large scale. They can execute massive projects, create industrial power, and meet social goals. They aren’t slowed down by lawsuits from individuals or environmental impact statements.
Planned economies can wholly transform societies to conform to the government’s vision. The new administration nationalizes private companies. Its previous owners attend “re-education” classes. Workers receive new jobs based on the government’s assessment of their skills.
This rapid mobilization often means planned economies mow down other societal needs. For example, the government tells workers what jobs they must fulfill. It discourages them from moving. The goods it produces aren’t always based on consumer demand. But citizens find a way to fulfill their needs. They often develop a shadow economy or black market. It buys and sells the things the planned economy isn’t producing. Leaders’ attempts to control this market weaken support for them.
They often produce too much of one thing and not enough of another. It’s difficult for the central planners to get up-to-date information about consumers’ needs. Also, prices are set by the central plan. They no longer measure or control demand. Instead, rationing often becomes necessary.
Planned economies discourage innovation. They reward business leaders for following directives. This doesn’t allow for taking the risks required to create new solutions. Planned economies struggle to produce the right exports at global market prices. It’s challenging for central planners to meet the needs of the domestic market. Meeting the needs of international markets is even more complex.
Here are examples of the most well-known countries with planned economies:
- Belarus: This former Soviet satellite is still a planned economy. The government owns 80 percent of the country’s businesses and 75 percent of its banks.
- China: After World War II, Mao Tse Tung created a society ruled by Communism. He enforced a strictly planned economy. The current leaders are moving toward a market-based system. They continue to create five-year plans to outline economic goals and objectives.
- Cuba: Fidel Castro’s 1959 revolution installed Communism and a planned economy. The Soviet Union subsidized Cuba’s economy until 1990. The government is slowly incorporating market reforms to spur growth.
- Iran: The government controls 60 percent of the economy through state-owned businesses. It uses price controls and subsidies to regulate the market. This created recessions, which it has ignored. Instead, it devoted resources to expanding its nuclear capability. The United Nations imposed sanctions, worsening its recessions. The economy improved once the nuclear trade deal ended sanctions in 2015.
- Libya: In 1969, Muammar Gaddafi created a planned economy reliant upon oil revenues. Most Libyans work for the government. Gaddafi had been instituting reforms to create a market-based economy. But his 2011 assassination halted these plans.
- North Korea: After World War II, President Kim Il-sung created the world’s most centrally-planned economy. It created food shortages, malnutrition and several bouts of mass starvation. Most state resources go into building up the military.
- Russia: In 1917, Vladimir Lenin created the first Communist Planned economy. The Russian people were ready for a radical change, having suffered starvation during World War I. Joseph Stalin built up military might and quickly rebuilt the economy after World War II. The Soviet State Planning Committee, or “Gosplan,” has been the most-studied planned economy entity. The USSR was also the longest-running planned economy, lasting from the 1930s until the late 1980s. Then, the state transferred ownership of the largest companies to oligarchs.
In 2018, planned economies like China, Russia and Iran have shifted towards more economic freedom, while North Korea and Cuba still remain economically repressed.
Development of the Theory
Viennese economist Otto Neurath developed the concept of a Planned economy after World War I. Neurath proposed it as a way to control hyperinflation. The phrase “Planned economy” comes from the German word “Befehlswirtschaft.” It described the fascist Nazi economy.
But centrally planned economies existed long before Nazi Germany. They included the Incan empire in 16th century Peru and the Mormons in 19th century Utah. The United States used a planned economy to mobilize for World War II.
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