Definition
A market economy is one in which the dominant mechanism for allocating resources is voluntary exchange between buyers and sellers, at prices determined by supply and demand. It is contrasted with command economies (where the state directs allocation), traditional economies (where custom dictates production), and gift or reciprocity economies.
Market economies are far older than capitalism — markets, money, and merchants existed in ancient Mesopotamia, medieval Europe, and pre-colonial Africa. Capitalism is a particular kind of market economy in which not only goods but also labour and capital are bought and sold, and in which the dominant productive units are firms operating under the imperative of profitable accumulation.
Why it matters
How it works
A market economy uses prices to do three things simultaneously: signal scarcity (rising prices say "make more, consume less"), allocate resources (buyers and sellers act on those signals), and motivate effort (those who supply scarce things get more income). When markets work well, this is extraordinarily efficient; when they fail — pollution, public goods, monopoly, financial instability — they require correction.
For capitalism, the decisive additional market is the labour market: the market in human capacity-to-work. A society can have markets for goods without having a labour market in the modern sense — and that distinction is what separates a market economy from a capitalist one.