III.0 A Functional Market Economy
A functional market economy is one that encourages and channels the creativity, initiative, and productive energy of its citizens, while simultaneously discouraging and constraining uncompetitive, rent-seeking, and predatory economic behavior. In such an economy, markets operate as mechanisms of allocation and discipline: they reward productivity, innovation and efficiency, while penalizing persistent inefficiency and misallocation of the resources. This understanding lies at the core of the EU’s concept of a “functioning market economy” as defined under the Copenhagen economic criteria.
The Role of the State
However, a functional market economy does not emerge spontaneously, nor does it sustain itself automatically. Left entirely to their own devices, markets tend to reproduce structural weaknesses, reinforce existing concentrations of power and tolerate unproductive forms of accumulation. Information asymmetries, coordination failures, externalities, natural monopolies, and unequal access to finance are not exceptions but inherent features of real-world markets.
In such conditions, market outcomes can diverge substantially from socially optimal or development-enhancing results, leading to underinvestment, low productivity growth, and persistent structural stagnation.
For this reason, the effective functioning of markets presupposes an active and capable state. State intervention in the free operation of markets is economically justified where market failures prevent efficient allocation, undermine competition, or inhibit long-term development. Importantly, this does not imply the replacement of markets by the state, but rather the deliberate shaping and disciplining of market outcomes in line with broader development objectives.
The central question is therefore not whether the state should intervene, but how it intervenes and with what institutional capacity.
The Developmental State
In this context, the concept of the developmental state becomes central. A developmental state is neither a minimal state that confines itself to basic regulation, nor a discretionary state that intervenes selectively without clear rules or accountability. Rather, it is a state that actively enables market functioning by:
- Setting stable and predictable rules
- Correcting market failures
- Investing in public goods
- Building the institutional and productive capacities necessary for sustained growth and competitiveness
Its role is to create the conditions under which markets can operate effectively, not to substitute for them.
Rule-Based Intervention
A key characteristic of a developmental state is that its interventions are rule-based rather than discretionary. Policy predictability, legal certainty, and equal treatment of market participants are essential preconditions for competition and investment.
Where state action is arbitrary or selectively applied, it undermines market discipline and encourages rent-seeking rather than productive entrepreneurship. By contrast, a developmental state disciplines both public and private actors through transparent rules, credible enforcement, and clearly defined policy objectives.
Addressing Market Failures
At the same time, a developmental state intervenes explicitly to address identifiable market failures. This includes supporting coordination in areas where private incentives are misaligned with long-term development goals, such as:
- Infrastructure provision
- Skills formation
- Innovation
- Structural transformation
Such interventions must be targeted, proportionate, and time-bound, and should be subject to clear performance criteria. State support that is not linked to measurable outcomes or that protects inefficient actors ultimately weakens markets rather than strengthening them.
Capacity Building Over Protection
Equally important, a developmental state focuses on building capacities rather than shielding inefficiency. Public investment in human capital, infrastructure, institutional quality, and innovation ecosystems enhances the productive potential of the economy.
However, continued support must be conditional on performance. Where expected results fail to materialize, state intervention should be withdrawn. Without such discipline, state action ceases to be developmental and instead becomes a source of distortion and dependency.
Accountability and Evaluation
Accountability and evaluation therefore represent essential pillars of a developmental state:
- Transparent decision-making
- Ex ante criteria for intervention
- Systematic ex post assessment
These are necessary to ensure that public action serves development objectives rather than entrenched interests. In the absence of accountability, even well-intentioned interventions risk reinforcing unproductive behavior and weakening competitive pressures.
The Business Environment
In its narrower usage, a conducive business environment is often understood as one that is predictable, protects property and contracts, and ensures competition through stable regulation and a level playing field.
From the perspective outlined above, however, the business environment should be understood as the outcome of the interaction between markets and a capable developmental state. Predictability, competition, and legal protection are not ends in themselves—they are mechanisms through which markets are enabled to allocate resources efficiently and support long-term productivity growth.
Strengthening the developmental capacity of the state is not an alternative to market-based development, but a prerequisite for a functional market economy capable of withstanding competitive pressure within the EU single market—and thus a core condition for Serbia’s EU accession.
Summary
A functioning market economy is one that effectively mobilizes private initiative while ensuring that market outcomes are disciplined by competition, sound institutions, and macroeconomic stability. Markets are expected to reward productivity and efficiency, but their effective functioning depends on the quality of economic governance and the state’s capacity to enforce rules, correct market failures, and provide key public goods.
This understanding is operationalized under the Copenhagen economic criteria. In practice, markets are characterized by structural imperfections—including information asymmetries, coordination failures, and unequal access to finance—which can result in underinvestment, weak productivity growth and reinforcement of existing concentrations of power if left unaddressed.
A capable state is therefore essential not to replace markets, but to shape and discipline them through predictable, rule-based interventions. Legal certainty, equal treatment of market participants, and policy predictability are central to ensuring competition and investment.
Core Dimensions of a Functioning Market Economy
This logic applies across the core dimensions of a functioning market economy. A developmental state intervenes explicitly to address identifiable market failures:
- Goods and services market: Requires a level playing field
- Financial market: Requires not only stability, but sufficient depth and access to finance, particularly for productive domestic investment
- Labor market: Requires incentives for participation, skills formation, and mobility, supported by targeted public policies
On the other hand, state support that is not linked to measurable outcomes or that protects inefficient actors ultimately weakens markets rather than strengthening them. In the absence of accountability, even well-intentioned interventions risk reinforcing unproductive behavior and weakening competitive pressures.
Copenhagen Criteria Requirements
A functioning market economy requires:
| Criterion | Description |
|---|---|
| Economic Governance | High quality of economic governance |
| Macroeconomic Stability | Including adequate price stability as well as sustainable public finances and external accounts |
| Goods and Services Market | Proper functioning, including business environment, state influence on product markets, and privatization and restructuring |
| Financial Market | Proper functioning, including financial stability and access to finance |
| Labor Market | Proper functioning |