____________________________________________________________________________________________________

Subject ECONOMICS

Paper No and Title 7: Theory of Public Finance

Module No and Title 4: Role of Government under Cooperation and competition

Module Tag ECO_P7_M4

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Role of government
4. Role of government under Cooperation and Competition
5. Summary

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

1. Learning Outcomes

After studying this module, you shall be able to

 Understand the role performed by the government in an economy.

 Understand the role of government under conditions of competition and
cooperation.

2. 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, the
governments across countries have assumed greater significance. The growing
complexities and problems associated with the 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 required an
effective government rule that could play a catalytic role, encouraging and
complementing the activities of the market and at the same time act as a provider of key
social and economic goods and services.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

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
and climate change etc. have necessitated the need for an effective government
intervention program that undertake and promote collective actions efficiently. The
following pages highlight the role of the government under conditions of competition and
cooperation.

3. 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 the 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 the prime example 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 Consumers choice and their sovereignty.
ECONOMICS Paper 7: Theory of Public Finance
Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

 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 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 the governments into three
categories– allocation of resources, redistribution of income, and stabilization of
economic activity. Another important role that can be added is promotion of growth and
employment. The government is involved in the allocation of resources through the
provision of public and merit goods such as defense, 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, the 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
defense. It also undertakes production activities along with the 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
ECONOMICS Paper 7: Theory of Public Finance
Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

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 among the poor at rationed prices. In another example, the
government procures goods to provide for national defense.

 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 interest of the 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 behavior. For instance, taxes on labor influences 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 unequal distribution of
income thus, 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 pattern 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 a bigger taxation and subsidy programs in order to
support the so-called “welfare state”.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

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 regulation of goods
produced under increasing returns to scale and control of externalities. Moreover, well-
established legal and regulatory framework 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 through creation of cooperative
and competitive environment for achievement of its social-economic objectives. The
right mix of cooperative and competitive forces is an essential requirement of efficient
allocation of scarce resources and for smooth and stable operation of government and
market agencies.

4. Role of government under competition and cooperation

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 behavior of

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

individuals and so on. The consequent distribution may or may not match the society’s
acceptable level of inequality. Thus, out of the concern of 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
the 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 growing globalization and 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 Antidiscrimination laws, wage legislations, 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.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

Changing and evolving social views and rapidly changing technologies exert significant
influence on the role of government. The government has a greater responsibility of
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 the society.

 Regulation:
Market exchanges require formal contracts and this, in turn, requires a regulatory
institution to register and enforce them. As discussed earlier, an effective regulation can
foster competition and innovation and, at the same time, can curb the monopolistic
tendencies. A well-established regulatory framework is an essential requirement for
protection of consumers, workers and environmental rights, moreover, it can help to alter
market outcomes conducive for 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 threat 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 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 the society (World Development report, 1997).
The need for formal institution 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

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

framework, and protection from unpredictable government actions. The unpredictable

judiciary, crime, and corruption have been found as a major constraint for business
activities.
The government protects the interest 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 in dominant firms and guide the market outcome through
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
behaviors.
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 cost associated with such problems.

The government plays a leading role in setting the incentive structure for the economic
agents to induce them to innovate, to improve productivity, and to allocate resources
efficiently. The process of market development critically depends upon the effectiveness
and reliability of institutions such as 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

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

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 policy 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 of 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 machineries. Dysfunctional and ill-thought-
out industrial and trade policy can cost countries dearly in terms of adverse micro and
macroeconomic environment.
 Managing Privatization:
The government can enhance the growth of markets by inviting private initiative 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 drain 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, Taiwan, where 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 in ensuring the
institutional foundations for market development. There are five fundamental tasks

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

before the government to ensure sustainable social-economic development. Theses are–

Ensuring macroeconomic stability, protecting the vulnerable, protecting environment,
investment 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 to social fundamentals. A state of lawlessness– high
levels of crime, violence, and poor judiciary are often an indication of marginalization of
some section of the society. Here, only 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 the 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 conducive investment climate in
such areas.
Another area where government intervention is sought is environmental regulation. The
growing concern of climate change and environment pollution has lead to increasing
government regulations in the form of pollution taxes and other levies to regulate
markets.
Yet another aspect of government role is ensuring economic security to 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 host of other measures can effectively
protect the interest of each section of the society.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

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. The Stable inflation rate,
stable balance of payment position and 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.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition
____________________________________________________________________________________________________

5. Summary

 Government intervention in a market economy is required to improve

microeconomic efficiency by correcting a market failure.
 The functions performed by a government can be classified into four categories–
allocation of resources, redistribution of income, stabilization of economic
activity, and promotion of growth and employment.
 The government plays an important role in the process of market development
through various measures such as regulation, redistribution, purchase of goods
and services, industrial policy, privatization, redistribution, setting up of legal
framework and securing social and economic fundamentals. The reliability and
capability of government institutions determine the extent to which the above
measures can successfully help in the process of social-economic development.

ECONOMICS Paper 7: Theory of Public Finance

Module 4: Role of Government under Cooperation and competition