Market system

After you have worked through this section of learning unit, you should be able to:

  • describe the main features of a market system and identify the strengths and weaknesses of the market system

The third way in which the economic problem can be solved is through the market economy. Markets as such are almost as old as the history of humankind itself and appear in both the traditional society and the command economy. The market economy, where consumption and production decisions, the allocation of production factors and the distribution of goods and services are all arranged through a system of market determined prices, is a recent development – it is not much older than 200 years. (A modern command economy also uses prices to organise consumption, production and the use of production factors, but these prices are not determined by the market, but unilaterally by the government.)

The market economy, like any other economic system, has to provide answers to the following fundamental economic questions:

  • Allocation. The problem of what to produce is determined by the consumer, that is, there is consumer sovereignty. Consumers display their preferences for goods and services in the market and the producers, in their pursuit of profit, react accordingly.
  • Production methods. The problem of how to produce is solved by the entrepreneur who, under coercion of competition, strives to combine factors of production in such a manner that production takes place at the lowest possible cost, thereby maximising profits.
  • Distribution. The problem of for whom goods and services are to be produced is solved in two steps. Firstly, the consumer's income is determined by the quantity of production factor(s) each offers, multiplied by the value (i.e. price) the market assigns to this/these factor(s). Secondly, the consumer uses this income to purchase those goods and services he or she desires.

While command economies have a highly centralised structure for economic decision making, market economies have a decentralised structure. Society’s resources are owned and operated by private individuals or groups of private individuals known as businesses. In a pure market economy, economic decisions are made through the free market coordination of individuals who are driven by their own self-interest.

A market is an institution (with or without a physical location) that brings together the buyers and sellers of goods or services, which may either be individuals or businesses. It is this interaction between buyers and sellers, known as free market coordination, that determines the price and quantity demanded of goods and services in the economy.

The market price reflects the underlying demand and supply conditions of the product. For instance, if the price of a product increases, this may be the result of an increase in demand or a decrease in supply. In response to this increase in the market price, buyers will decrease the quantity of the product they demand, while suppliers will increase their production in order to take advantage of the higher price for their goods. If one supplier charges a price that is above the equilibrium market price, then consumers will simply buy from other suppliers, thus forcing the supplier to reduce its price or go out of business. It is this kind of competition that regulates the market and keeps it functioning efficiently.

In a market system, a person's income is based on his or her ability to convert the factors of production (labour, land, capital and entrepreneurship) he or she owns into something that society values. If an individual is incapable of converting his or her factors of production into something society values, he or she will not be rewarded. This means that a person unable to contribute to society would go hungry without the help of others like a family member or a good Samaritan. In reality, almost all nations have some type of social welfare system run by their government to help these people. Government receives tax revenue and directs some of it to social welfare programmes to help those who cannot help themselves. Government also provides national defence and other public goods and services which cannot be efficiently provided by the free market. A pure market economy does not have a government, which is why there are no real-life examples of countries with a pure market system.

Watch the following section of the video clip about the market system from 9:30 minutes to 13:42 minutes before you do the activity:


Now do the following activity:

Which of the following are primarily responsible for making economic decisions in a pure market economy?

Think again. .

It is in a command system that the central government is the most important decision maker. In a pure market economy, the decisions are made by individual consumers and suppliers.

Think again.

In a pure market economy, the decisions are made by individual consumers and suppliers and not large corporations.

Think again.

It is in a command system that the central government as well as regulators and bureaucrats are important decision makers. In a pure market economy, the decisions are made by individual consumers and suppliers.

Indicate whether the following statements are true or false:

In a pure market economy, the “for whom” or distribution question is largely answered according to the needs and wants of individuals and groups in society.

Think again.  The statement is false.

In a pure market economy, you need an income in order to purchase goods and services to satisfy your needs and wants. It is the needs and wants of those with income that are satisfied.

In a pure market economy, the price mechanism plays an important role in solving the economic problem.

You are right! The statement is true.

In a market system, it is the forces of demand and supply which determine the prices of goods and services, and consumers and suppliers make decisions on the basis of these prices.

In a market system, prices are determined by government bureaucrats.

Think again. The statement is false.

In a market system, prices are determined by the forces of demand and supply. Bureaucrats set prices in a command  system.

A strength of the market system is that it provides an incentive for people to work hard.