"I am no longer the coach of the Paraguayan national team as of today," Argentine Martino, who took Paraguay further than they had ever reached at the World Cup finals in South Africa, told a news conference.
Arce, who won more than 60 caps between 1995 and 2004, said he would attempt to improve Paraguay with a more attacking game which Martino had found hard to implement.
"First [we must] improve our ball possession, look for more alternatives from the middle forward," Arce, a man of slight build nicknamed "Chiqui", told reporters.
"We have that profile and we won't do anything different from what is known of our work at local level," said Arce, who has had remarkable success with modest first division side Rubio Nu since 2007 in his only coaching job.
"I don't know if it will work as quickly as it did at Rubio Nu but when you can choose among the best, among top players, that job will be more consistent."
Arce, 40, has less than three months to prepare for Paraguay's opening of South America's 2014 World Cup qualifiers in October.
FOUR-YEAR TENURE
Martino had been in the Paraguay job for four years after winning league titles with top local clubs Libertad and Cerro Porteno.
"I consider I can no longer contribute to everything we imagined when we took the reins of the national team," the 48-year-old former Newell's Old Boys and Argentina midfielder said.
"After the World Cup we imagined a scenario of more growth [but] I believe we have hit a plateau where results are in one place and the team's performances have been in another place," he added after his team were criticised for their poor play during the Copa America in Argentina.
Paraguay did not win a match in the Copa America, reaching the final with five draws including two penalty shootout victories before losing to Uruguay 3-0 in Sunday's decider.
Martino said after the final that the shooting of Paraguay's top player Salvador Cabanas in the head a Mexico City bar in January of last year, six months before the World cup finals, had been a major blow to the team's progress. Cabanas recovered but is unlikely to play professionally again.
Although Paraguay had their best qualifying campaign for the 2010 finals, their 11 competitive matches since have yielded only one victory, over Slovakia in South Africa.
They beat Japan on penalties in the round of 16 and lost to eventual champions Spain 1-0 in their quarter-final.
