The Market Economy

"Entertainment from '90210' to movies, rock, and rap is a hotbed for fashion trends. For instance, [fashion designer, Irma] Zandl has noticed that Guns n' Roses' Axl Rose has been appearing in public in what looks like his great-granny's drawers, and she suspects that this may turn out to be a trend. It sounds weird but, once we get used to it, it probably won't seem stranger than bike shorts which, by the way, according to Teenage Research Unlimited, are definitely out now."

The situation described in this quotation from a 1992 United Press International article would be meaning­less in a traditional or a command economy. Changes in clothing styles in a traditional society could occur only over a period of many years. In a command econ­omy, those who make the decisions might bow to pub­lic pressure and produce clothing like Axl Rose wears, but they probably would not. In a market economy, or free enterprise system, if consumers want granny drawers, clothing manufacturers will react quickly and begin producing the new style.

A market economy is one in which the decisions of many individual buyers and sellers interact to answer the questions of What, How, and Who.

In addition to buyers and sellers, there are several other essential elements in a market economy. One of these is private property. Private property means individuals and business firms have the right to own the means of production. Although markets exist in traditional and command economies, the major means of production (such as firms, factories, farms, and mines) typically are publicly owned. That is, groups of people or the government own them. But in a market economy private individuals own the means of production. Private ownership gives people the incentive to use their property to produce things that will sell and earn them a profit.

This desire to earn a profit is a second ingredient in a market economy. Often referred to as the profit motive, it provides the fuel that drives sellers to pro­duce the things that buyers want, at prices they are willing to pay.

The profit motive also gives sellers the incentive to produce at the lowest possible cost. Why? Because lower costs enable them to (1) increase their profit margins, the difference between cost and selling price, (2) reduce prices to undersell the competition, or (3) both.

Economists often compare markets to polling booths—the places people vote for political leaders. Markets provide a kind of economic polling booth for buyers to cast their votes (in the form of purchases) for the goods and services they want. Producers can earn profits if they interpret the votes correctly by producing the things that buyers demand. But those who interpret the voting incorrectly—producing too much or too little or charging a price that is too high or too low—do not earn profits. In fact, they often lose money.

Consumer votes can be a matter of life and death to business in a market economy. Chapter 8 introduces some of the things that firms can do to determine what consumers want, and create a demand for goods and services where none previously existed.

Mixed Economies. What most distinguishes com­mand economies from market economies is the role of government and the ownership of the means of pro­duction. You have read that in command economies factories, farms, stores, and other productive resources are government-owned. Here government planners answer the economic questions of What, How, and Who. In contrast, market economies depend on the decisions of individual buyers and sellers to answer the same questions, and the means of production are privately owned. Government plays a relatively minor part in this model.

There are, however, no pure market economies in the world today. While we can say that markets account for most economic decisions in the United States, government has been playing an ever-widen­ing and important role. For example, 50 years ago government purchased 15 percent of all American goods and services. It now purchases 20 percent.

This blend of market forces and government partici­pation has led economists to describe the U.S. eco­nomic system and those of most other democratic countries as mixed economies.

Further, recent changes in the economies of the for­mer Soviet Union, China, and certain other commu­nist countries have served to bring elements of the market into those command economies. As the number of pri­vately owned businesses has increased, they too are developing the features of mixed economies.