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Fridays Academy: Government in the Economy

Ignacio Hernandez's picture

From Raj Nallari and Breda Griffith's lecture notes.


Today's posting discusses the role of government in the economy and the rationale for government, before turning to a consideration of fiscal policy and its impact on economic growth and on the poor during the next few weeks.



Under ideal circumstances, markets will allocate resources efficiently.  Markets are not perfect, however, suggesting a role for government.  For example, the government can tax or regulate negative externalities (e.g. pollution), produce public goods (e.g. defense), redistribute income, and define and enforce property rights. It can also be argued that the government may have a role to play in stabilizing the economy using monetary and fiscal policies. Fiscal policy deals with the various uses of taxes and public expenditures.


Role of Government in the Economy

Government can provide the legal framework and services needed for the effective operation of a market economy. To do this, government has five primary functions in economic development:

  1. Providing a legal and social framework

  2. Providing public goods

  3. Government regulation

  4. Reallocating resources

  5. Stabilizing the economy

The existence of a problem in the market (or “market failure”) does not automatically mean that government intervention can allocate resources more efficiently. A substantial amount of information is required to find the optimal allocation of resources, meaning that “government failure” may end up being worse than the original market failure it was meant to address.


Another issue is that at times there will be conflicts among the government’s many goals.  If the government pursues redistributive goals, for example, by transferring income from one group of people to another through higher taxes, this may reduce the efficiency of resource allocation.  Thus, there can be an explicit trade-off between efficiency and equity.  Also, even where enough information exists to solve a problem in the market, the government might not act efficiently. Interest groups will always become involved in public policy issues that affect them directly, and their interests are not necessarily the interests of the general public.


1. Legal and social framework

By creating a sound legal framework, government sets the legal status of business enterprises and ensures the right and protection of private ownership, a key factor in encouraging entrepreneurship within a country’s borders. By establishing the legal rules of the game the government directs the relationships between businesses, resource suppliers and consumers, thus fostering an improvement in resource allocation, which in turn aids the poverty alleviation effort.The protection of individuals’ rights to the goods and services they exchange in a market system is almost everywhere provided by government, although private sector protection can often complement government protection.  Three basic institutions are used to protect individual rights in a market economy: police protection, national defense and the courts and criminal justice system. By protecting individual rights, the government creates a system permitting individuals to interact with each other through voluntary agreement, thereby reserving the legitimate use of force to the government.   Another important function of government is facilitating the enforcement of contracts, which allows citizens to operate with confidence that legal recourse is available should a colleague or a client fails to fulfill their commitments. 


The protection of rights and enforcement of contracts is necessary for a functioning economy.  This protection makes up a sizable fraction of the public budget.  Countries with the best developed laws and regulations also enjoy a higher level of economic activity than those which provide few safeguards.  The democratic model of checks and balances uses one branch of government to constrain the others, while democratic election of officials can also have the effect of constraining the power of government.   


2. Provision of public goods

Public goods and externalities provide the main theoretical justifications for government production. 


Public goods are those that can be enjoyed by an unlimited number of people (nonrival) without prejudice of each other and where one cannot exclude people from using them (nonexcludable) (e.g., light houses, defense; law and order; and parks). Public goods are also indivisible; they must be produced in such large units that they cannot ordinarily be sold to individual buyers. Because of these characteristics, it is unfeasible to charge for the consumption of public goods and therefore private suppliers will lack the incentive to supply them. 


Externalities or spillovers occur when some of the costs or benefits of a good are passed on or spill over to parties other than the immediate seller or buyer. Some externalities have a beneficial effect on others and are referred to as positive externalities and others have a detrimental effect and are referred to as negative externalities.  Pollution is an example of a negative externality while the positive spillover effects of investment in R & D, training, or education are examples of positive externalities. The market, left on its own will tend to produce too many goods and services involving negative externalities (indicating a need to tax them or impose restrictions) and too few goods and services involving positive externalities (indicating a need to subsidize them or have them provided publicly). 


3. Government regulation

Regulation is applied in cases in which the private sector allocates resources inefficiently but where the imposition of rules can provide incentives for more efficient private sector production without the government having to take over production itself.


For example, the market does not provide regulations for property rights, financial markets, a judicial system for the enforcement of contracts, labor or environmental legislation, trade legislation, health and safety standards, etc. In these circumstances, the state should step in and either provide these services directly or regulate the providers of these goods and services. Given that monopolies do not have the incentives to produce efficiently and charge appropriate prices, there is a role for the state to regulate here.  Government can control monopolies either by regulating prices or setting service standards under anti-monopoly laws. In cases where monopolies cannot be avoided and may have particularly detrimental effects, it may be best for the public sector to provide the good or service in question directly.


Good regulations that are well designed allow markets to operate efficiently; conversely, bad regulations interfere with market operations. Developing countries tend to have too few of the good kind of regulation (property rights, well-functioning judiciary, environmental and financial market regulation) and too many of the bad kind of regulation (many steps required to obtain a license to open a business, overregulation of trade, marketing boards, regulating prices, and so on).


The stability of regulation is also important: one of the most damaging sources of state action is uncertainty.  One needs to be assured that the rules and regulations of an economy, the protection of property rights and the provision of public goods are not subject to continuous change. Only in this way can society function optimally and only in this way will it act as a magnet for investment.


4. Redistribution

At first glance, the reasons why government might engage in some redistribution of income might appear obvious, but a closer look reveals that there are a few closely related rationales for redistribution.  One underlying principle is to use public policy to improve the well-being of those members of society who are least fortunate, providing a safety net for people who have fallen on hard times and ensuring that everyone has access to some minimal standard of living. Alternatively, greater equality might be desired as a social goal. Although these two goals have a similar ring to them, note that they are different goals and might imply different public policies. Helping the poor is not necessarily the same thing as promoting greater equality.


Obviously, the poor in wealthy nations tend to be better off than the poor in poorer nations, suggesting that improving the well-being of the poor can be consistent with increasing everyone’s standard of living.  At the extreme, the goal of equality could be achieved by confiscating the wealth of above-average wealth holders and giving it to those below average until everyone's wealth is the same.  This would destroy the incentive to be productive and would result in equality by creating a very poor society for everyone. This extreme example shows that the goals of equality and the alleviation of poverty are not necessarily the same.


Although a market economy benefits society as a whole, it does not benefit everybody. There are always winners and losers. Whatever the origin of unequal income distribution may be, each society decides how much state intervention they want to use to even it out.  The features shared by the most egalitarian societies are a public education and health system, unemployment insurance and public pension systems and a well-developed welfare state.


The design of policies aimed at redistribution will depend on what goals the policies/programs are intended to accomplish.  Public education is redistributive in that it provides everyone with an equal opportunity. The tax system represents another way of redistributing income.  Higher taxes on upper-income individuals will further the goal of equality but might reduce the incentive for upper-income individuals to earn income, resulting in less total tax revenue.  Likewise, taxation of investment income can discourage saving and investment, making the economy less productive.  This will further the goal of equality, but perhaps at the cost of reducing economic growth and making those at the lower end of the income scale worse off, too.  Issues like this must be considered when designing a tax system, but a different tax structure will be called for depending upon whether the goal of redistribution is to create more equality or whether it is to help those who are the least fortunate in society. 


5. Stabilization

Stabilization policies are designed to address short-run fluctuations in economic activity. These fluctuations, which are caused by demand (e.g., lower demand for exports by partner countries) and/or supply side shocks (e.g., the quadrupling of oil prices in the 1970s), can be eased by using fiscal and/or monetary policy. Stabilization policies can in turn be of the automatic or active variety. 


One example of an automatic stabilizer is unemployment compensation: if the economy goes into recession, unemployment compensation payments automatically increase as people become unemployed.  Tax payments also typically decline as activity decreases. These forms of stabilizers provide channels through which the volatility of economic activity is automatically suppressed moving through the business cycle.


Active stabilization policies are another option. These were very popular in the post-second World War period (postwar model) because the conventional wisdom was that one of the key reasons for the great depression was the failure of the Federal Reserve and the government to react and cut interest rates and increase expenditure. However, in the 1970s, many governments found that these policies did not work if the "short" side (or limiting side of the economy to the generation of faster growth) is not the demand side but rather the supply side. If a government attempts to use expansionary policies (creating more demand through expansionary monetary or fiscal policy) in an economy with the supply side either at full employment or below full employment but without ability to expand due to some bottle neck or rigidity, it leads to inflation (thus the stagflation of the 1970s) and, if it is an open economy, to a balance of payments deficit (as imports increase). Since the 1980s there has been increasing skepticism about activist countercyclical macroeconomic policy, especially on the fiscal side, which is typically harder to activate and fine tune. And, although monetary policy is seen to have some role in helping to stabilize economic activity, it is now widely held that the primary goal of monetary policy should be low inflation.


Next week: Fiscal Policy. Public Expenditure and Finance


Submitted by Sokol Domniku on
The Goverment's effect must come from three dimensions: Stimulating the Economical sector's like: Industry, Tourisme, Commerce or Busines. The most developed Contry's in the world in economical aspect have this sector's as primary assets. In my Country, in Kosovo (frm. YU), we have much of natural resources that can be very helpfull in preparative of this sectors. Also, the components that are subscribed in this article are included as a very important factors that must be as a Key factors to keep one Country established in economical aspect , and specially in aspect of Employment growth or stabilisation.

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