We hear the term "market economy" batted about frequently in the news, most recently in the context of China's desire to be recognized as a market economy by the European Union. We know that in the United States we operate in a market economy, but how is that defined, and what exactly does it mean?
In a market economy (sometimes called a "free market economy"), the principles of supply and demand determine what is produced, how it is produced, and by whom it is produced and consumed. How do we make use of limited resources? Do we grow figs or grapes? Do we invest in fossil fuels or renewable energy? Producers make these decisions based upon the market. They determine what is in high demand and what will yield the most gain.
The price of a good or service arises through myriad voluntary transactions and indicates to a producer what the demand is for that good or service and whether or not it would be a good allocation of resources. Buyers and sellers enter into transactions without coercion or control from any outside forces, and market competition for both buyers and resources arises naturally.
The opposite of a market economy is a planned economy, also called a command economy. In this model, government assumes a leading role in deciding what goods and services should be produced and who the producers will be.
During the twentieth century, both China and the Soviet Union were examples of large planned economies in which the government controlled many aspects of production and pricing. In 1978, China began transitioning gradually towards a market economy by allowing the market to dictate pricing in some sectors while retaining government control in others. This dual or mixed economy strategy has over the past quarter of a century made China the fastest-growing major economy in the world.
In practice, there is no such thing as a pure market economy. In the United States, as in most economies, there is a balance of free market forces and necessary governmental controls. Such controls include subsidies for public goods such as education, transportation, and communications. Examples of government intervention in the U.S. economy include the nationalization of rail travel (Amtrak), laws against drug use, and the protection of property rights.
At the national, state and local level, government is responsible for the regulation of activities from emissions to zoning to food and drug standards. Government agencies also monitor and control activities that result in externalities, unintended social consequences of economic activities such as groundwater contamination or climate change, and it is crucial that they do so. There will, of course, always be debate as to what is the correct balance of free market and government influence.