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Economics for Everyone: Role of Government - Part 1

India Infoline News Service | Mumbai | April 11, 2013 11:18 IST

A central function of any democratic government is to promote the social and economic well-being of its people. This would require governments to achieve macroeconomic stability, create employment opportunities, promote innovations, ensure high standards in the area of environmental quality, safety etc.

Context:


PM Dr Manmohan Singh Tells Industry to Shun Negativism.

Prime Minister highlighted the steps taken by the government for restoration of macro-economic balance as a step towards higher growth.


Govt. and industry are partners in progress: Manmohan Singh

"As different governments have steered the economy through the complex task of implementing economic reforms, CII has consistently pushed the business case for reforms and helped our country to achieve its full economic potential," 


Content:

  1. Role of Government and Economic Planning
  2. Role and Evaluation of Government
  3. Basic problems of an economy and the role of government
  4. THE ROLE OF GOVERNMENT IN MANAGING THE ECONOMY
  5. INSTRUMENTS USED FOR MACROECONOMICS GOALS
  6. Markets and Government Intervention
  7. Reasons for government interference in markets.
  8. Forms of intervention.
  9. ROLE OF GOVERNMENT- ECONOMIC THEORETICAL BACKGROUND
  10. Free Enterprise or Laissez Faire System: 
  11. Socialist Economy:
  12. Socialism vs Capitalism a comparison
  13. Mixed Economy: (EX-INDIA)
  14. CENTRAL TASKS OF A SOCIETY
  15. CAPITALISM AND THE CENTRAL TASKS
  16. Socialism and the Central Tasks
  17. Mixed Economics and the Central Tasks
  18. Impact of government on managerial decision making.
  19. Macroeconomic policy
  20. Industrial policy
  21. Competition policy
  22. Regional policy
  23. Environmental policy

Role of Government

If you own or manage a business in the U.S, government is your nor-so- silent partner. Your pricing and marketing practices will be affected by federal and state antitrust statutes. Even the products labels will be affected by government regulations - Stephen Walters in his  Enterprise, Government and the Public. 


A central function of  any democratic government is to promote the social and economic well-being of its people. This would require governments to achieve macroeconomic stability, create employment opportunities, promote innovations, ensure high standards in the area of environmental quality, safety etc. Regulations is an important tool that is being increasingly utilised by governments for achieving these public policy objectives to ensure smooth functioning of democracy. 


In most of the advanced economies today the state has a major role with government expenditure and taxation. The role of government extents beyond the provision of social and economic services, such as education and health care, to establishing and policing, limiting business activities for protecting the environment, maintaining the infrastructure, and to provide safety net in the shape of unemployment, sickness and disability benefits.


Let us start with a brief examination about the role of government in modern economies.


Role and Evaluation of Government

How does one evaluate a government and the quality of its governance?  Economists and corporate strategic planners are often called upon to evaluate the possible effects of various policy options and measures contemplated or implemented by government.  In addition, they are often asked for recommendations about whether or not to undertake a given policy.  Evaluating economic policy in this way means you are going beyond just describing possible outcomes and are making normative judgments. To do so, some criteria by which policy options can be evaluated are needed.


The criteria most frequently applied to economic policy options are:

  • Efficiency in allocation and utilization of resources 
  • Equity:  promoting and safeguarding the interests of multiple constituents and contributing to fairness and social justice.
  • Growth promoting economic growth and incomes
  • Stability - of the economy.

Basic problems of an economy and the role of government

Whatever the nature of the economic system, all economies have been confronted with certain common basic problems. The major economic problems faced by an economy may be classified into two broad groups: (i) micro-economic problems which are related to the working of the constituents of the economic system; and (ii) macro-economic problems related to the growth, stability, and management of the economy as a whole.


The way the basic problems of an economy are solved depends on the nature of the economy. While in a socialist economy they are solved by government agencies, like the central planning authority, in a free enterprise [Laissez Faire] or mixed capitalist economy this task is performed by the Price Mechanism or Market Mechanism. Though the free enterprise system is capable of ushering economic growth, it does not ensure a stable, sustained, and balanced growth. It therefore becomes inevitable for government to intervene in order to promote fair competition, and help the economy in achieving its goals efficiency, stability, growth and economic justice.


The question arises:  what should be the appropriate role of government in the economic management of the country?  Put another way, what should be the form, nature and extent of governments interference with the market mechanism.


Governments  intervention in the economy can be both direct and indirect.  On the one hand it can be directly engaged in economic and business activities through controlling and managing public sector enterprises.  On the other hand government also controls and regulates the private sector through its industrial, monetary and fiscal policies. In such case, the intervention is indirect.  If necessary, direct controls are also imposed.


The economic role of the government depends on the kind of economic system that is in place.  We can broadly categorize three economic systems which have been prevalent in the world, viz., Capitalist System or Free Enterprise System, Socialist System, and the Mixed-Economy System.


THE ROLE OF GOVERNMENT IN MANAGING THE ECONOMY

  1. Establishing the legal framework for the economy (ex competition law, SEBI, TRAI, IRDA)
  2. Affecting the allocation of resources to improve economic efficiency.
  3. Establishing programs to improve the distribution of income.
  4. Stabilizing the economy through macro economic policies.

INSTRUMENTS USED FOR MACROECONOMICS GOALS

A nation has a wide varieties of policy instruments that can be used to pursue its macroeconomics goals.


Fiscal Policy: (public finance, taxation, budget)

Consists of govt. expenditure and taxation.Govt expenditure influence the relative size of collective as opposed to the private consumption. Taxation subtracts from income and reduces private spending, in addition it affects investment and potential output. Fiscal policy affects total spending and there by influences real GNP and inflation.


Monetary Policy (interest rate, banking sector policy)

Monetary policy conducted by central determines the money supply. Changes in the money supply moves interest rates up or down and affect spending in sectors such as investment housing and net exports. Monetary policy has an important effect on both actual GNP and potential GNP and also the banking sector.


Foreign Economic Polices- EXIM policy, FOREX policy, FDI, FII policy)

Trades polices, Exchange rate setting and monetary and fiscal polices attempt to keep imports in line with exports to stabilize forex rates. Govts co-ordinate these policies to achieve their macroeconomic goal.


Income generation Policies - MNREGA), Stimulus packages


Markets and Government Intervention

Reasons for government interference in markets.

The pursuit of fairness - in the distribution of income (for current and future generations) and in the allocation of merit goods like education, health and housing.

The regulation and control of harmful goods like drugs, alcohol and tobacco.

Avoid  demerit goods which people might otherwise over-indulge in.

  • Raising revenue.
  • Forms of intervention.
  • Price controls
  • Taxes on commodities
  • Regulation
  • Other examples are
  • Imposing a Minimum Wage
  • Taxing Commodities and Stabilising Prices

Why tax goods and services? (Some of the objectives)

1. To raise revenue

2. To deter the consumption of harmful commodities (e.g., tobacco, alcohol)

3. To encourage the conservation of scarce resources (e.g., petroleum)

4.To discourage environmentally harmful activities (e.g., polluting activities)


Role of Government- Economic Theoretical Background


Free Enterprise or Laissez Faire System: 


In this system, the primary role of the government are to:

  • Preserve and promote the free market mechanism wherever possible to ensure a workable competition,
  • Remove all unnecessary restrictions on the free operation of competitive market,
  • Provide for a level playing field and set the rules of the market game through necessary interventions and controls, so that free competition can work effectively.

We may infer that governments role in a capitalist society is supposed to be limited to (a) restoring and promotion of necessary conditions for efficient working of free market mechanism; and (b) entering those areas of production and distribution in which private entrepreneurship is lacking or is inefficient.


Socialist Economy:

In contract with the capitalist system, the role of government in a Socialist economy is much more exhaustive. While in the former, the government is supposed to play a limited role in the economic sphere, in the latter, it exercises comprehensive control on almost all economic activities. In the socialist system, not only there is a complete disregard for free enterprise and market mechanism but also these systems are abolished by law. The private ownership of factors of production is replaced by State ownership. All economic activities are centrally planned, controlled and regulated by the State. All decisions regarding production, resource allocation, employment, pricing etc., are centralized in the hands of government or the Central Planning Authority.


Given below is the snapshot of the principal features, merits and demerits of capitalism and socialism in the table below.


Socialism vs Capitalism a comparison

Socialism (command economy)Capitalism (market economy)
  • Features
  • Social ownership of means of production
  • Government control
  • Central Planning
  • Society based on equality
  • Social welfare
  • Classless society
  • Equitable distribution of income
  • MERITS
  • Maximum social welfare
  • Sectoral balance
  • Full employment
  • Central planning avoids wastes of competition
  • Equitable income distribution
  • Monopoly is avoided.
  • DEMERITS
  • Assumptions are not always valid
  • Misuse of power results in corruption and inefficiency
  • Planning for all sectors is complicated
  • The plan cannot be altered and may be rigid.
  • Due to absence of private profit , there is no incentive to increase production
  • Planning involves huge expenses
  • Features
  • Individual freedom
  • Consumer sovereignty
  • Private property
  • Price mechanism and competition
  • Self interest and Personal profit motive
  • Laissez- faire policy
  • Absence of central planning
  • MERITS
  • Automation
  • Freedom and choice
  • Private property
  • Encouragement of enterprise
  • Inefficiency discouraged
  • Optimum allocation of resources
  • No government intervention
  • DEMERITS
  • Wastage
  • Assumptions are not valid always
  • Absence of competition ( Monopoly)
  • Instability
  • Inequalities of income and wealth
  • Society based on different economic class
  • Self interest

Mixed Economy: (Example-INDIA)

In this system, a major part of the economy, namely the private sector, is allowed to function on the principles of free enterprise system or free market mechanism within a broad political and economic policy framework.


The other part of the economy, the public sector, is organized and managed along the socialist pattern. The public sector is created by reserving certain industries, trade, services, and activities for government control and management.  Government prevents, by an ordinance, the entry of private capital into those industries reserved for the public sector. Another way of creating or expanding the public sector is nationalization of existing industries. The promotion, control and management of the public sector industries are the sole responsibility of the State.


Apart from controlling and managing public sector enterprises and industries, the government controls and regulates the private sector through its industrial, monetary and fiscal policies. If necessary, direct controls are also imposed.


Central Tasks of a Society

The major considerations of any society in the economic field, irrespective of the way in which it is organized, are what to produce, how to produce and for whom to produce. What to produce implies that the society must determine by some method what kinds of goods and services should be produced and how much in each category. Guns or butter is a classic way of describing this dilemma of choice, but this is not the only alternative faced by a society, which will have to decide on the composition of output in terms of investment goods such as machines, and consumption goods such as food. Amongst the consumption goods, it will have to decide on the allocation of necessities versus luxuries. What and how much to produce are interrelated. Economics as a science not only analyses the different mechanisms through which these choices are made, but also probes into implications of alternative choices on the growth and welfare of society.


How to produce entails decisions on the appropriate combinations of different resources for producing a commodity. In popular terms, it refers to the technique of production to be adopted. Each technique has a different combination of machine and labour. For example, in the production of cloth, the techniques vary from labour intensive production of khadi to the comparatively more capital intensive method of production through a textile mill. Broadly speaking, the factors that influence the choice of techniques are the technology available and the relative availability of different factors of production. A country with a large population will prefer labour intensive techniques more than a country with a limited population. Economics examines the factors behind such decisions.


Lastly, a society must also decide how goods and services must be shared by different members of society. The distribution of income is as important as its generation. There is no society where all enjoy the fruits of production equally. The organization of the economic system determines the distribution of shares among different sections of society. Though production and distribution are two different activities, the organization of the productive system does determine the share of products.


Capitalism and the Central Tasks

In a purely feudal system, the three main tasks mentioned earlier are performed according to the dictates of a strictly hierarchical system of society. While few have the freedom to decide what they want, the needs of the bulk of society are determined only by status. The capitalist system makes a break with the feudal system in so far as decisions are determined by contract rather than by custom. The essential characteristic of the capitalist system is the private ownership of resources or means of production. It allows each individual or firm the freedom to own resources and to produce goods and services.


How does such a system solve the main tasks of what, how, and for whom to produce? The broad answer is that the market mechanism helps to solve these problems.


Society consists of two classes of people: producers and consumers. The producer in a capitalist system is motivated by the desire to make profits. The decision to produce a commodity will be determined by the costs incurred and the price at which it can be sold. The consumers desire certain goods and services. However, their ability to fulfill their wants is conditioned by their income. The market provides the link between producers and consumers. If producers quote a price that is deemed to be high by consumers, the producers will find that they have produced more than the consumers are willing to buy at that price. Thus a process is set in motion which will eventually lead to a situation when one price emergesthat at which producers are willing to supply, and that which consumers are willing to pay. For this reason the capitalist system is described as a process of trial and error.


The same market mechanism is credited with solving the problem of how to produce. Here the producers face a market for productive resources. They demand the factors of production, and the owners of these factors of production offer their services. Thus the factors markets decide the prices of the factors of production and producers decide the factor combinations in the light of these prices.


The last task of distributing the national product essentially flows from the two previous decisions. Factor markets results I the distribution of income since all human beings earn their income market through selling their labour or entrepreneurial ability. The product market distributes goods and services according to the desires of the consumers and their incomes.


Capitalism is individualistic with self-interest being the primary driving force. It is a decentralized, decision-making system. In spite of this, it does not necessarily lead to chaos, as individual decisions are influenced by the demands of society which are reflected through the market. The critics of the capitalist system, while admitting that the market mechanism can solve the problem of resources allocation, draw attention to some serious flaws in the operation of market forces. The market for consumption goods, for example, rations supplies among consumers. But the consumers willingness to pay what is reflected in this market depends on the distribution of incoure. With a highly unequal distribution of income, even in a very poor society, the market will signal the need for the production of goods and services deemed to be luxuries. The basic necessities of life which are essential for the masses will not be produced adequately since the market will not beneficial. The deficiencies of the market are even more pronounced when the amount and composition of investments are allowed to be determined by a multitude of investment decisions made by individuals. Such decisions may result in the non-optimal allocation of resources since they ignore or are incapable of taking into account the benefits arising from a set of complementary investments. These factors are of special significance for developing economies.


Pure capitalism where individuals or business firms enjoy unfettered freedom to own and produce does exist anywhere. Government intervention is necessary even for the effective operations of the market. Most of the benefits attributed to the mechanisms accrue only when there is a high degree of competition. Government intervention has been considered essential to prevent the emergence of monopolistic tendencies. Also, the private-enterprise-dominated system has revealed that the operation of market forces does not ensure a level of income that will maintain employment. Fluctuations in the overall level of economic activity have compiled governments in these countries to intervene in the market to prevent incomes from falling. Such interventions are described as stabilization policies.


Socialism and the Central Tasks

A pure socialist society does not permit individuals ownership of the means of production. The society or the state representing the society owns the means of production. How does such a society solve the basic problems of what, how and for whom to produce?


The state or the central planning authority makes decisions. The planners first decide how much of the national product should be invested for future growth. The rest of the resources are then available for the production of consumer goods. The kinds of consumer goods to be produced and the quantity of each are decided by the planners pre-under capitalism. However, in recent years in advanced socialist countries like the Soviet Union where wants have become more and more sophisticated, it has been found necessary to allow the play of price mechanism. But this role even now is limited. In deciding on how to produce a commodity, technology plays the same role as it does under capitalism. Under capitalism, the other important consideration of the prices of the factors of production is determined by the factor market. But under socialism, economic valuation of the factors of production is done by the planners taking into account the overall availability of resources and the demand for these resources. The Soviet planners have found that in the absence of such valuation, resources may be wasted.


For whom to produce is determined by a variety of state decisions ranging from the allocation of national production between consumption and investment, to the determination of wages and wage differentials.


While the socialist systems avoid taking major decisions through the operations of market forces, they nevertheless use prices for regulating and allocating goods and services. After having decided how much of the national product is to be invested, they manipulate the prices of consumption goods so that they are equal to the total wages paid. More recently economics efficiency has experiments have been attempted in using the market mechanism without sacrificing the basic postulate of social ownership of the means of production.


Mixed Economics and the Central Tasks

Even though pure capitalism and pure socialism are at polar ends, a large number of countries have characteristics of both. India is a typical example of such a country. The state not only plays the role of regulating the economy but also directly participates in the production and distribution of goods and services. The Planning Commission, planning authority, makes crucial decisions on how to produce and hat to produce. Thus we have a system in operation in which a part of the decisions is centralized and the rest is left to be determined by market forces. A later chapter will elucidate the mode and effectiveness of planning under such conditions.


Impact of government on managerial decision making.


One of the principal factors in the external economic environment of a business is the role of government.  A business enterprise can be impacted in a number of ways by government planning and policy measures these may cover various aspects like licensing;  foreign participation;  taxes;  investment opportunities; labour market conditions. 


Changes in economic policy have a major impact not only on the political environment but on the economic, social and technological future that an industry faces. For example, higher interest rates can be expected to slowdown economic activity lead to higher unemployment reduce political support for the  government and affect the level of investment in new technology and R&D. An understanding of the nature of government economic policy is therefore crucial to successful managerial decision making. 

  • As discussed above the policy instruments of state (government) intervention can be grouped under  

  • Macroeconomic policy

  • Industrial policy

  • Competition policy

  • Regional policy

  • Environmental policy

  • Macroeconomic policy

Government macroeconomic policy is concerned with the regulation of the level of economic activity. It therefore impacts directly on businesses by affecting the level of consumer demand and the cost of raising capital (through interest rates). Economies are complex and to many managers fluctuations in economic activity must seem hard or predict. However, managers need to have some understanding of the nature of macroeconomic policy if they are to anticipate successfully the consequences for their trades of policy changes, e.g. a rise in interest rates. It is important to appreciate why governments alter interest rates, taxes and spending and how the level of economic activity and hence consumer demand are likely to respond. Firms that ignore the macroeconomic environment and policy are likely to be underestimating the business dynamics and changes and may take an inappropriate business decision and strategy.


In addition to encouraging or discouraging competition where there are appreciable external benefits or external costs respectively governments also intervene in the markets for the following other reasons:

  • To regulate the level of economic activity- Great depression story

  • To protect consumers and employees

  • To alter the free market distribution of income and wealth.

  • Subsidy or taxation of products

  • Prohibiting licensing or regulating suppliers

Industrial policy

All effect on policies have some effect on business, but industrial policy is concerned with those policies which are  intentionally adopted by governments with a view to influencing the development of particular industries, sectors of the economy or firms. Industrial policy impacts on business structure and business restructuring.


A market economy, even though, functions with less government intervention is naturally associated with constant change resulting, in particular, from changes in overall economic and market environment, changes in technology and consumer demand. Consequently, at given time some industries and businesses will be expanding while others are contracting. A problem can arise, however, in terms of adjustment costs during this transition time. The decline of an industry can mean high unemployment and social deprivation. For these and related reason, governments have felt the need to introduce industrial policies to speed up or slow down economic change.


Accelerative industrial policies are designed to speed up the adjustment process, for example by providing soft loans, tax allowances, state subsidies and restructuring grants. By contrast decelerative policies are intend to slow down the pace of change, usually through financial aid, and are directed at industries in serious decline. In both thee case the state intervention may be either aimed at one firm or selected firms or spread across an industry or business sector.


The various types of industrial policy in this regard are

  • National champion policy (picking winners strategy where the state/government attempts to help and provide financial aid to build up a major and internationally competitive enterprises)

  • Development of sunrise industries (such as IT, Biotech, Telecom which usually take advantage of new technologies)

  • Lame  duck strategy(subsidies or financial aid provided to a declining or failing firms)

  • Problem industries (subsidies or protection for selected industries from external impact)


  Intended effect on the pace of economic change
Type of selective government  assistance
AccelerativeDecelerative
To one (or a few) selected firms National champion strategyLame duck strategy
To an industry or sectorDevelopment of sunrise industriesProblem industries

Thus the industrial policies aim at picking winners and supporting losers. Presently there is a movement towards more liberalizing the markets i.e. less control and more roles for market mechanism and nations across the world are opened their market and globalizing their market which allows for free flow of goods, services and labour across the markets. Also, governments across the world reducing their stakes in their public sectors. This is known as liberalization,privatization and globalization. This topic would require a separate discussion.


Competition policy

The fundamental objectives of regulatory reforms (concerning a particular market) is to infuse dynamic efficiency in different systems influencing the market. (A market is said to be efficient when all available information which may influence the price of the product/service is reflected in the price of the product/service. This implies that there exists near perfect competition in the market i.e. a large number of buyers and sellers, firms are offering identical products, there exists free entry and exit, no barrier to entry and players have a perfect knowledge of the market.) This automatically inculcates discipline in the market players.


According to the World Bank, Competition policy refers to government measures that directly affect the behavior of enterprises and the structure of industry. An appropriate competition policy includes both:

(a) policies that enhance competition in local and national markets, such as liberalized trade policy, relaxed foreign investment and ownership requirements, and economic de-regulation, and

(b) Competition law, also referred to as antitrust or antimonopoly law, designed to prevent anticompetitive business practices by firms and unnecessary government intervention in the marketplace.


Objectives of competition law:

Competition law generally contains conduct and structural provisions relating to business activity. The conduct provisions of competition law primarily relate to:

  •  Horizontal agreements between firms to fix prices, engage in bid-rigging, restrict output and/or market shares, allocate geographic markets and, or customers.

  • Abuse of market positions by large dominant firms. Vertical restraints between suppliers and distributors such as resale price maintenance (RPM), exclusive dealing and geographic market restriction.

The primary structural provisions of competition law relate to mergers, acquisitions and joint ventures. Of these, the principal competitive concerns lie in the area of horizontal as against vertical/conglomerate mergers and acquisitions.


According to the World Bank, the principal objective of competition law should be to maintain and encourage competition as a vehicle to promote economic efficiency and maximize consumer welfare. The focal point of competition law should be the actual and/or potential business conduct of firms in a given market and not on the absolute or relative size of firms. This requires that instead of penalizing large firm size or industry concentration competition authorities should assess whether a firm (or group of firms) can exercise "market power", i.e., engage in business practices which substantially lessen or prevent competition. This is possible only when existing or potential competition is insufficient to constrain such behavior indicating barriers confront new entry and competition.


The implication of this is that competition law needs to focus not only on the business conduct of firms but also on the business environment in which the firms operate. The latter results in examining the impact of various other government economic policies. Thus, over and above the substantive provisions generally contained in competition law, these policies represent potential instruments to maintain and encourage competition. Effective harmonization and linkages between competition law and other government policies must therefore be attempted. Altering the business environment so as to promote competition, not only constrains anti-competitive behavior by firms, it also inculcates sound business practices and ethics.


In India the present new Competition Policy, has been introduced by repealing the Monopolies & Restrictive Trade practices Act, 1969(MRTP).


Regional policy

The economic and social divide between regions with high percapita income growth and low unemployment, and the more depressed regions with lower purchasing power and high unemployment is considered to be economically, politically and socially undesirable. The initiatives by the state/government to correct these imbalances is known as the regional policy.


Prof. M.Guruprasad, AICAR BUSINESS SCHOOL


SOURCES:

NEWS PAPERS

MACROECONOMICS - C.RANGARAJAN, B.H.DOLOKIA

The Essence of Business Economics JOSEPH G. NELLIS & DAVID PARKER


Note:

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Cabinet Secretariat

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