A market is a medium which facilitates the exchange of goods and services between buyers and sellers. A market can be physical or virtual and is defined by the different goods and services exchanged in it. A market facilitates the transactions between two or more parties who exchange goods and services, (most often) money, information, or anything of value to the selling party. The interaction of buyers and sellers in the market determines the supply and demand of the goods and services being exchanged and therefore the price and quality of the goods is also determined.
A market economy or free market is a market that is unrestricted by regulation and the economy is therefore subject to the market forces. The free market is an economic structure pioneered by Adam Smith in his work, The Wealth of Nations. The model is driven by supply and demand where there is perfect competition, buyers and sellers may transact as they please and government regulations do not obstruct or control the transactions. Taxation and other government regulations can disrupt this free exchange and sometimes disrupt the equilibrium creating inefficiencies. In a free market, instead of governments making economic decisions it is the interactions between buyers and sellers which determine the direction of the market.
Market economies are not ‘perfect’, however, the absence of government regulation allows certain market structures to emerge and change the way a market operates. There a number of ways in which a free market can produce inefficient outcomes or undesirable market structures such as externalities, monopolies, oligopolies and others. These structures can distort prices by restricting supply or demand. The under-supply and imperfect price standardization in a market creates a deadweight loss in the economy which causes inefficiencies in the market and can have negative effects. Free markets are inherently prone to an unequal distribution of wealth in the economy, this is often measured using the Gini coefficient.
A market economy can produce externalities. Externalities are effects experienced by third parties as a result of economic activity. These effects can be either negative such as pollution from burning coal for electricity, or positive such as the implementation of higher safety regulations at nuclear power plants. A negative externality occurs when the social cost is greater than the production cost or private cost. This means that the parties creating the externality do not take into account the negative effects of their actions. If coal-fired power plants do not employ equipment to reduce the harmful effects of emissions then there is a greater social cost as emissions can affect the health of those living close to the plant.
A positive externality occurs when the social cost is less than the private cost thus creating a potential gain in welfare or an increase in social good. There are ways in which a free market can compensate for negative externalities created by its unregulated activities without government intervention or the implementation of regulation. These are called market solutions. One such way is the Coase theorem which suggests that if there is a desire to correct a negative effect they experience, they can incentivize or compensate the party creating the effect to stop a certain activity or introduce another. The population living around a coal plant (perhaps the municipal government) could pay the plant to implement the new technology in order to reduce the negative effects caused by its emissions.