A market economy is a system where the laws of Supply and Demand directly 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 command 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 economic.

Key Takeaways

• A market economy functions under the laws of supply and demand.
• It is characterized by private ownership, freedom of choice, self-interest, optimized buying and selling platforms, competition, and limited government intervention.
• Competition drives the market economy, optimizing efficiency and innovation. 
• Market economies marginalize those that are unable to compete, contributing to income inequality.

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. Their assets give them the right to profit of ownership. There are some assets U.S. law excludes. Since 1865, for example, you cannot legally buy and sell human beings.3 

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.

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.

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.

System of Markets and Prices

A market economy relies on an efficiency in market 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 determinant of Demand : product price, buyer's income, prices of related goods, consumer taste, buyer's expectations.

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 penalize monopolies that restrict competition. It makes sure no one is manipulating the markets and that everyone has equal access to information.5 

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.1 

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 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 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, 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.1

If it decides it is, society will grant the government a significant role in redistributing resources. That is why many market economies are also mixed economies. Most so-called market economies are mixed economies.

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A Guide for an Entrepreneurs, Business Leaders & and Investors

When we wish to assess the performance of a business, we’re looking for ways to measure the financial and economic consequences of past management decisions that shaped investments, operations, and financing over time. The important questions to be answered are whether all resources were used effectively, whether the profitability of the business met or even exceeded expectations, and whether financing choices were made prudently. Shareholder value creation ultimately re- quires positive results in all these areas which will bring about favorable cash flow patterns exceeding the company’s cost of capital.

As we’ll see, there is a wide range of choices among many individual ratios and measures, some purely financial and some economic. No one ratio or measure can be considered predominant. We’ll demonstrate primarily the analysis of business performance based on published financial statements. These represent the most common data source available for the purpose, even though they are not designed to reflect economic results and conditions. We’ll also discuss the more important measures that help assess economic performance aspects. Our focus will be on key relationships and indicators that allow the analyst to assess past performance and also to project assumed future results. We’ll point out their meaning as well as the limitations inherent in them. In the final we’ll discuss the larger context of valuing a company or its parts in economic terms, a process that is based on an intense assessment of performance drivers and strategic positioning, and that requires developing expected cash flow results for which past performance is only a starting point.

Ratio Analysis and Performance

Because there are so many tools for doing performance assessment, we must re- member that different techniques address measurement in very specific and often narrowly defined ways. One can be tempted to “run all the numbers,” particularly given the speed and ease of computer spreadsheets. Yet normally, only a few selected relationships will yield information the analyst really needs for useful insights and decision support. By definition, a ratio can relate any magnitude to any other; the choices are limited only by the imagination. To be useful, both the meaning and the limitations of the ratio chosen have to be understood. Before be- ginning any task, therefore, the analyst must define the following elements:

• The viewpoint taken.
• The objectives of the analysis.
• The potential standards of comparison.

Any particular ratio or measure is useful only in relation to the viewpoint taken and the specific objectives of the analysis. When there is such a match, the measure can become a standard for comparison. Moreover, ratios are not absolute criteria: They serve best when used in selected combinations to point out changes in financial conditions or operating performance over several periods and as com- pared to similar businesses. Ratios help illustrate the trends and patterns of such changes, which, in turn, might indicate to the analyst the risks and opportunities for the business under review.

A further caution: Performance assessment via financial statement analysis is based on past data and conditions from which it might be difficult to extrapolate future expectations. Yet, any decisions to be made as a result of such performance assessment can affect only the future—the past is gone, or sunk, as an economist would call it.

No attempt to assess business performance can provide firm answers. Any insights gained will be relative, because business and operating conditions vary so much from company to company and industry to industry. Comparisons and standards based on past performance are especially difficult to interpret in large, multi business companies and conglomerates, where specific information by individual lines of business is normally limited. Accounting adjustments of various types present further complications. To deal with all these aspects in detail is far beyond the scope of this book, although we’ll point out the key items. The reader should strive to become aware of these issues and always be cautious in using financial data.

To provide a coherent structure for the many ratios and measures involved, the discussion will be built around three major viewpoints of financial performance analysis. While there are many different individuals and groups interested in the success or failure of a given business, the most important are:

• Managers.
• Owners (investors).
• Lenders and creditors.

Closest to the business on a day-to-day basis, but also responsible for its long-range performance, is the management of the organization, whether its members are professional managers or owner/managers. Managers are responsible and accountable for operating efficiency, the effective deployment of capital, useful human effort, appropriate use of other resources, and current and long-term results—all within the context of sound business strategies.

Next are the various owners of the business, who are especially interested in the current and long-term returns on their equity investment. They usually expect growing earnings, cash flows, and dividends, which in combination will bring about growth in the economic value of their “stake.” They are affected by the way a company’s earnings are used and distributed, and by the relative value of their shares within the general movement of the security markets.

Finally, there are the providers of “other people’s money,” lenders and creditors who extend funds to the business for various lengths of time. They are mainly concerned about the company’s liquidity and cash flows that affect its ability to make the interest payments due them and eventually to repay the principal. They’ll also be concerned about the degree of financial leverage employed, and the availability of specific residual asset values that will give them a margin of protection against their risk.

Other groups such as employees, government, and society have, of course, specific objectives of their own—the business’ ability to pay wages, the stability of employment, the reliability of tax payments, and the financial wherewithal to meet various social and environmental obligations. Financial performance indica- tors are useful to these groups in combination with a variety of other data.

The principal financial performance areas of interest to management, owners, and lenders are shown in Figure below , along with the most common ratios and measures relevant to these areas. We’ll follow the sequence shown in the figure and discuss each subgrouping within the three broad viewpoints. Later, we’ll re- late the key measures to each other in a systems context.

Management’s Point of View

Management has a dual interest in the analysis of financial performance:

• To assess the efficiency and profitability of operations.
• To judge how effectively the resources of the business are being used.

The Financial Markets and Innovation in Productivity of Economy in Tanzania