Introduction
The role of government in the social-economic sphere has evolved considerably over a period of time. As societies develop and become complex, heterogeneous and specialized, the necessity for agreements or contract rules becomes bigger. Therefore, governments across countries have assumed greater significance.
The growing complexities and problems associated with market failure necessitate the need for government intervention in economic activities through direct and indirect channels, such as through the direct provision of certain goods and services, regulation of industries and trade through various rules and regulations.
Post the World War II period, the government was regarded as vital for the provision of goods and services and for the establishment of the rules and institutions that would allow efficient market functioning and ensure sustainable social and economic development. The expansion in government spending was driven by post-war confidence in government and a gradual move towards the mixed economy system in many of the industrial countries.
In underdeveloped and developing countries, the process of social and economic development requires an effective government rule that could play a catalytic role, encouraging and complementing the activities of the market and, at the same time, acting as a provider of key social and economic goods and services.
The success of a mixed economic system requires effective coordination between the government and the market forces. The role of the government is no longer static. Global integration of economies, technological changes, problems of poverty, unemployment, climate change, etc., have necessitated the need for an effective government intervention program that undertakes and promotes collective actions efficiently.
The following pages highlight the role of the government under conditions of competition and cooperation.
Role of Government
Prior to the First World War, the role of government was limited to activities such as the maintenance of law and order, ensuring internal and external security, and the provision of important public goods.
The Great Depression of 1930 laid the foundation for the participatory role of government in economic activities in terms of promoting aggregate demand and ensuring a high rate of employment. It was seen as the failure of the markets, and there was growing popularity for Keynesian demand management tools.
Since then, governments across countries have been an instrumental force in promoting economic development and securing economies from economic vulnerabilities. They are increasingly involved in almost every aspect of the economy, such as administrating prices, financial markets, regulations and other social-economic areas.
The recent international economic downturn and the subsequent government intervention programs for uplifting the economies from it are prime examples in this regard. The size of government spending has increased many-fold since the subprime crisis of 2008 due to government intervention in financial markets and economic stimulus programs to push the economies out of the crisis.
Following are some important features that highlight the role of government in an economy-
- The simultaneous existence of the Public and the Private sector and effective coordination between the two.
- Allocation of Resources through the price mechanism and government directives.
- Protection of Consumer’s choice and their sovereignty.
- The arrangement of definite economic planning for the Public Sector enterprises.
- The government intervention and regulation of profits of the private sector.
- Promotion and ensuring the Social Welfare of the citizens.
- Implementation of effective fiscal policy and monetary policy conducive to economic development.
- Encouragement of technological progress to promote efficiency in the economy.
Musgrave (1959) has classified the functions performed by governments into three categories:–
- allocation of resources,
- redistribution of income, and
- stabilization of economic activity
Another important role that can be added is the promotion of growth and employment. The government is involved in the allocation of resources through the provision of public and merit goods such as defence, health, and education. It also takes care of the problem of externalities through taxes and subsidies.
The degree of governmental intervention is determined by the level of achievement in all these tasks and by the nature of externalities. Under the distribution function, the government undertakes activities that ensure equity and efficiency.
The market activities often promote inequitable distribution of income and poverty, and thus, the government intervenes through its taxation and subsidy programs to correct this market failure. The stabilization branch is concerned with programs that aim to ensure economic stability– conditions of full employment, stable prices, and a desirable macroeconomic environment.
In short, government activities fall into the following categories:
● Production of Goods and Services: The government is responsible for the production of certain goods and services such as roads, ports and items of national defence. It also undertakes production activities along with private firms, such as electricity generation. In India, at the rural level, the government is responsible for the provision of services such as health and education at reasonable prices.
● Purchase of Goods and Services: The government also purchases goods and services from the market meant for further production or for subsidized distribution. For example, the government procures food grains from the market and sells them to the poor at rationed prices. In another example, the government procures goods to provide for national defence.
● Regulation and Subsidization of Private Production: An important aim of the government is to curb monopolistic tendencies of market players and ensure reasonable prices of goods and services. It aims to correct the market failure associated with externalities and public goods. The regulations also aim to protect the interests of consumers, workers, and the environment. Thus, the government regulates the activities of private organizations through regulatory measures such as quotas, taxes, and other such measures. For example, a carbon tax is imposed on factories that emit greenhouse gases. It also collects taxes, and that alters economic behaviour. For instance, taxes on labour influence the incentives to work, while taxes on specific goods (e.g., diesel) change the influence the production and consumption decisions.
● Redistribution of Income: Equity is an important objective to maximize social welfare. The markets are often criticized for promoting the unequal distribution of income. Thus, the government intervenes to solve the problems of inequality and raise the standard of living. The government redistributes income through modes of taxes and subsidies to achieve objectives of equity and efficiency. Moreover, redistribution policies gain more importance in developing countries, given their problems of unemployment, poverty, and inequitable patterns of income distribution. Developing and undeveloped countries’ redistributing income programs tend to require more resources and governmental intervention. These governments tend to spend more on public services, such as education, health, and bureaucracy, leading to bigger taxation and subsidy programs in order to support the so-called “welfare state”.
Another important role played by the government in a mixed economy system is to provide a legal framework within which all economic transactions between firms and individuals can take place. It also allows the government to regulate an industry. The two areas where such operating standard is particularly important are the regulation of goods produced under increasing returns to scale and the control of externalities.
Moreover, well-established legal and regulatory frameworks help in reducing market costs, thereby improving efficiency and market operations. Economic activities would be severely restricted in the absence of well-defined property rights, as individuals would have little incentive to accumulate assets. Apart from defining property rights, the government also enforces contracts and agreements between individuals.
The following section discusses the role of government in the creation of a cooperative and competitive environment for the achievement of its social-economic objectives. The right mix of cooperative and competitive forces is an essential requirement for the efficient allocation of scarce resources and for the smooth and stable operation of government and market agencies.
Role of Government under Cooperation and Competition
The justification for the government intervention lies in the problems associated with the operations of the markets. Considering a hypothetical situation of a free market economy, where an economy is perfectly competitive and individuals have perfect information.
Under such a case, the equilibrium situation will be Pareto-efficient; that is, no one can be made better off without someone else being worse off. Individuals maximize their respective objective functions and thus, government intervention is not considered necessary for the achievement of efficient outcomes.
The need for government intervention in this situation arises from the fact that Pareto efficiency does not ensure equitable distribution. The patterns of income distribution depend upon a number of factors such as ownership of assets and financial resources, the propensity to save, skill level, demographic factors, and risk-taking behaviour of individuals and so on.
The consequent distribution may or may not match the society’s acceptable level of inequality. Thus, out of the concern for equity, poverty and unemployment, the government is expected to intervene in the social-economic sphere. The government, through redistribution policies, can achieve the twin objectives of equity and efficiency.
Moreover, the economy may not be perfectly competitive. The government regulates the activities of firms and keeps the monopolistic tendencies of firms under check. There are industries such as electricity where firms enjoy increasing returns to scale in the initial stages of production.
Such firms tend to capture a significant portion of the market by creating artificial barriers to entry and restricting output to raise prices. If businesses become monopolies, the benefits of competition are lost, and resource allocation under such situations is generally not Pareto-efficient.
The need for the government to enforce competition arises because markets do not behave efficiently in the presence of imperfect competition or in the absence of essential information with market participants. Laws and regulations create an environment within which fair and competitive markets can exist and that can guide the activities of firms and individuals to achieve desired ends.
With the growing globalization and the development of societies, the need for regulatory institutions has increased tremendously. Government intervention in a mixed economy can be illustrated through the following examples-
- In the input market- through anti-discrimination laws, wage legislations, and laws related to bargaining.
- In the output market- through direct provision of certain goods and services, that is, public and merit goods, purchase of goods and services, consumer protection laws, tariffs, subsidies and quotas on domestic and international trade, etc.
- In the Business sector- through public utility regulations, monopolistic restrictions, corporate income taxes, etc.
- In the household sector- through inheritance laws, personal income taxes, transfer payments, welfare schemes etc.
Changing and evolving social views and rapidly changing technologies exert significant influence on the role of government. The government has a greater responsibility for promoting the welfare of all the individuals comprising the society. It plays its role through the set of rules, laws and institutions that regulate the economy.
The process of development requires markets to grow, which in turn depends upon the capabilities and effectiveness of government institutions. Let us understand the ways in which the government affects the decision-making process and the economic activities of various economic agents in society.
● Regulation:
Market exchanges require formal contracts and this, in turn, requires a regulatory institution to register and enforce them. As discussed earlier, effective regulation can foster competition and innovation and, at the same time, curb monopolistic tendencies. A well-established regulatory framework is an essential requirement for the protection of consumers, workers and environmental rights.
Moreover, it can help to alter market outcomes conducive to achieving public ends. The government, through regulation, protects and benefits the society at large or some subclass of it. It has the power to potentially threaten or help a vast number of industries.
The task of regulation is to explain the form of regulation, decide who will receive the burden or benefits and what will be the impact of regulation. Effective regulation is instrumental in fostering growth.
For example, due to regulatory reforms in Chile, during the 1980s, the telecommunication industry attracted sustained private investment, improved competition and service quality, and declining prices. Whereas, as a result of a dysfunctional regulatory framework, the Philippine telecommunication industry lost on investment, led to high prices and imposed a high cost on society (World Development Report, 1997).
The need for formal institutions also arises to protect the property accumulated by individuals and to establish property rights. Well-established property rights are essential for the process of economic growth and poverty reduction. The effectiveness of property rights depends upon three conditions– fair and stable judiciary, efficient law and order framework, and protection from unpredictable government actions. The unpredictable judiciary, crime, and corruption have been found to be major constraints for business activities.
The government protects the interests of the markets and the public through the establishment of competition and consumer laws. Competition laws prevent the abuse of monopoly power in the hands of dominant firms and guide the market outcome by ensuring enough competition in the markets. It aims to ensure a level- playing field for all the market participants. Consumer laws are established to protect the interest of the consumers from probable exploitation by firms and to take care of changing consumer behaviours.
Apart from them, the government assumes the responsibility of bridging the information and coordination gaps faced by the markets in the form of asymmetric information and moral hazard problems. Well-functioning government institutions can significantly reduce the costs associated with such problems.
The government plays a leading role in setting the incentive structure for the economic agents to induce them to innovate, improve productivity, and allocate resources efficiently. The process of market development critically depends upon the effectiveness and reliability of institutions such as the security of property rights and enforcement of contracts. The government ensures that the rules are enforced consistently and are not changed unpredictably.
The credibility of government institutions has a significant influence on the business environment and on the outcome of development projects. A fair and predictable judicial system can make the process of complex transactions easier. In the absence of a well-developed judicial system, firms tend to use other ways of enforcing and monitoring contracts.
● Industrial Policy:
The government, especially in underdeveloped and developing countries, can encourage industrial development by reducing coordination problems and gaps in information. An effective industrial policy can secure social, economic and institutional fundamentals necessary for economic growth.
The Industrialized countries used various mechanisms to spur up their growth process. Developing countries need well-sought-out industrial and trade policies to face growth challenges.
The Indian government announced a package of various measures to spur up the Indian economy through the industrial policy of 1991. The aim was to correct distortions in the industrial sector. The industrial policy sought to liberate the industries through the abolition of the licensing system, gradually opening up the economy and reducing the role of the public sector. The government also enhanced its support to the small-scale industries and took measures to increase the competitiveness of the industries.
The success of industrial policy also depends upon the administrative and institutional capabilities of the government machinery. Dysfunctional and ill-thought-out industrial and trade policies can cost countries dearly in terms of adverse micro and macroeconomic environments.
● Managing Privatization:
The government can enhance the growth of markets by inviting private initiatives in areas where government enterprises are not performing efficiently. The term privatization refers to the process of transfer of ownership of publicly owned assets to entities that intend to utilize them with the aim of profit maximization. Privatization provides a solution to the problems of an ill-performing public sector that drains out national resources.
In India, the government has actively pursued the process of privatization to reform the public sector enterprises and to enhance industry competitiveness. Countries such as China and Taiwan, where the government chose to allow private sector development along with the public sector, witnessed positive economic benefits in terms of improved revenues, productivity and efficiency gains, beneficial structural changes and sustainable competitive advantage.
● Securing Social and Economic Fundamentals:
The government plays an important role in complementing the markets and ensuring the institutional foundations for market development. There are five fundamental tasks before the government to ensure sustainable social-economic development. These are– Ensuring macroeconomic stability, protecting the vulnerable, protecting the environment, investing in social overheads, and establishing a firm legal and regulatory foundation.
Weak government institutions are a hindrance to private sector growth, squander government credibility and hurt the social and economic welfare. Sustainable economic development requires a high priority on social fundamentals.
A state of lawlessness– high levels of crime, violence, and the poor judiciary are often an indication of the marginalization of some sections of the society. Here, only the government can ensure that the fruits of growth are equally shared and adequate protection is provided to the citizens from social-economic insecurities.
The underdeveloped and developing countries face a lack of private investment in social overhead capital and as a result, the process of economic development is held up in the early stages.
The task of development of social and economic infrastructure lies in the hands of the government, and provision of them creates external economies for the development of market institutions. They can even call for private sector participation and, thus, coordinate to create a conducive investment climate in such areas.
Another area where government intervention is sought is environmental regulation. The growing concern about climate change and environmental pollution has led to increasing government regulations in the form of pollution taxes and other levies to regulate markets.
Yet another aspect of the government’s role is ensuring economic security for its citizens. It is deeply important for developing countries facing problems of poverty, unemployment and income inequality.
The market operations are often criticized for causing economic vulnerabilities and aggregating economic problems of the marginalized section. The government, through its redistributive policies and a host of other measures, can effectively protect the interests of each section of society.
The tremendous growth of China and the East Asian nations during the last three decades is a prime example of government economic policies that support economic growth. Their success stories are an example of how coordination between the private and the public sector can bring beneficial results for an economy. There are three sets of policies that are instrumental in the growth process–
- Ensuring macroeconomic stability
- Liberal trade and investment policies
- Avoiding price distortions
As discussed, these policies help an economy to benefit from competitive forces and provide the right incentives and signals for economic agents. A stable inflation rate, stable balance of payment position and a more open outlook towards international trade and investment are key to the process of sound economic progress.
A right mix of fiscal and monetary policies, along with effective investment in social overheads and considerable investment in people, are the important ingredients of an effective government intervention program.
Strong government institutions are essential requirements for promoting competition or even efficient coordination between the market agents; as such, governments can act as brokers of information and facilitators of mutual learning and collaboration and thereby play a market-enhancing role in support of economic development.
Read More in: Theory of Public Finance
- Public Finance: Meaning, Nature & Scope
- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
- Preferences: Meaning, Types & Problems of Preference Revelation
- Preference Aggregation & Its Mechanism
- Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
- Economic Theory of Democracy: Concept & Explanation
- Politico Eco Bureaucracy: Concept & Explanation
- Rent-Seeking and Directly Unproductive Profit-Seeking Activities
- Rationale for Public Goods: Concept & Explanation
- Benefit Theory or Voluntary Exchange Theory
- Lindahl Model: Concept, Equilibrium & Limitations
- Bowen Model: Concept, Advantages & Limitations
- Samuelson’s Model of Public Expenditure
- Musgrave’s Model of Public Expenditures
- Demand Revealing Schemes for Public Goods
- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
- Effect of Distributional Inequality on Stabilization Policy
- Effect of Regional Imbalances on Stabilization Policy
- Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
- Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
- Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
- Pure Theory of Public Expenditure
- Structure & Growth of Public Expenditure in India
- Trends, Lessons & Priorities in Public Expenditure in India
- Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
- Performance Based Budgeting and Zero Based Budgeting
- Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
- Tax System and Its Principles
- Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
- Ability to Pay and Benefits Received Principle of Taxation
- Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
- Deadweight Loss of Taxation: Causes, Measurement & Example
- Concept of Equity & Efficiency in Economics
- Trade-Off Between Equity and Efficiency: Meaning & Example
- Theory of Measurement of Dead Weight Loss
- Double Taxation: Meaning, Desirability, Forms & Solution
- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment