Economy according to (Mankiw & Taylor 2006) is a Greek word for “one who manages a household” Household and economies are seen to be similar in the sense that they both face many decisions, decisions ranging from who does what, and who gets what must be made daily in a household. Likewise in our societies, decisions must be made on different issues such as who will do a certain job and so on. All these decisions would have not been difficult to make if lived in a world of abundance where everybody can have all they want, instead we live in a world of limitations which mean that household cannot provide all the wants of its member, likewise economies cannot provide everything people wish to have because of scarcity of resources, therefore choices must be made of what to have and what not to have, so economics studies the “choices of consumers, businesses, and government official s make to attain their goals given their scarce resources” (Hubbard &O`Brien 2008).

In making these choices, there are three major questions that any economy must answer, which are:

What good and services to be produced? How to produce these goods and services? Who will receive these products?

To be able to answer these questions economies are organised in two major ways which are:

• Centrally planned or command economy in which all economic decisions are taken by the government.
• Free market or market economy in which there is no government intervention at all, all economic decisions are taken by households and firms.

This essay intends to focus on free or market economy, how it works the role of market in it and describes the interaction among market and economic agents with the use of a simple circular diagram.

Development

In order to efficiently examine market economy, there is a need to understand what market is, Market is an institution or arrangement by which a group of buyers and sellers of goods and services come together to trade (Hubbard & O`Brien 2008). It is a place where consumers and suppliers interact to exchange their goods, services and information. Generally market is a place where any type of trade takes place. Market is totally dependent on consumers who are the demanders of commodities and sellers who are the suppliers of these commodities. There are different forms of market set up, markets can be physical places where buyers and sellers gathered together to trade like pizza chops, or supermarket stores, they can also be an invisible set up like telephone or online stores.

In a Market economy set up, all decision such as resources allocation, production, consumption, prices and competition are made by the coming together of two sets of people known as the economic agents these are households and firms as they interact in market of goods and services. A British economist Adam smith made a very famous observation in economics in his book An inquiry into the nature and causes of the wealth of nations1776, he observe that “households and firms interacting in the market acts as if they are guided by an invisible hand that leads them to desirable outcomes”

This concept can be well understood through this use of a simple microeconomic model known as the circular flow diagram; this diagram shows the interactions between economic agents in various market set up and the flow of money round in the economy. However in market economy decisions concerning production and consumption are made purely by firms and households (krugman et al 2008), there is no government intervention at all, thus a simple circular flow of income diagram below: