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Subject ECONOMICS

Paper No and Title 7: Theory of Public Finance

Module No and Title 3: Role of government in a mixed economy – public and

private sector
Module Tag ECO_P7_M3

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Concept of Mixed economy
4. Role of government in a Mixed economy
5. Summary

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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1. Learning Outcomes

After studying this module, you shall be able to

 Understand the concept of Mixed economy.

 Understand the role performed by the government in a mixed economy system.

2. Introduction

The Classical economists were proponents of Laissez-faire – a government free market

system. They advocated limited government intervention and believed in the existence of
‘an invisible hand’ that would restore full employment in the economy. However, the
Great Depression of 1930s exposed the loopholes and vulnerabilities associated with the
price mechanism and the market system. The period of 1920-30s saw the rise of
Keynesian economic theory that forcefully argued in favor of government intervention in
the economic activities. It argued that fiscal policy can generate employment and can
maintain it at high levels too. There was a growing concern for greater equity via income
distribution. The subsequent periods saw the expansion of government role in social and
economic activities across countries. Moreover, the rise of command economies of the
Soviet Union and the Eastern European economies created pressure for a larger
government role in social-economic affairs. Various intellectuals saw virtues in these
upcoming economic systems and the market oriented economies such as US gradually
moved towards a ‘mixed economy system’ with increasing government expenditures.
The term “mixed economy” was introduced to describe an economic system that match
the characteristics of the pure market and the planned economy forming a mix of
competitive and non-competitive mechanisms of creation, distribution and application of
national resources. The whole theory of mixed economy has been established as the

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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growth of the role of the government and the creation of public sector in a capitalist
economy.

The following pages summarize the role of government in a mixed economic system.

3. Concept of Mixed Economy

The Great depression sowed the seeds of government participation in economic activities.
It exposed the problems associated with the market system and called for active
government participation, as, in Keynes view, the public was not satisfied with the
private sector. Keynes called for fiscal measures to spur up investment and demand in the
economy. He argued that public spending on social and economic infrastructure can
provide the necessary boost to the economy and raise effective demand and thus can be
instrumental in economic growth.
In preceding years, there was a growing consensus among the policy makers that markets
can fail and government has all the required expertise, knowledge and resources that can
correct market failure. Apart from protecting the nation, it can arrest growing
inequalities, can curb poverty, generate employment, raise investment and stabilize the
economy. Economists came to believe that higher level of public spending can
compensate for the lack of private investment and can make the economy recession-
proof.
Apart from economic developments, political developments also played a part in the
growing government presence. Both Socialist and fascist ideologies arising from the
Soviet Union and Eastern European nations pushed for an overwhelming role of
government in allocation of resources and income distribution. The increasing popularity
of the government’s action contributed to the rise of public spending in market-oriented
economies such as the US, Canada, United Kingdom and Australia.
Thus, the period of the 1950s and 60s saw a rise of market economies or ‘welfare states’
in some countries and marked the end of Laissez-faire. In the US the public expenditure
ECONOMICS Paper 7: Theory of Public Finance
Module 3: Role of government in a mixed economy – public and private
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as a percentage of GDP rose from 9.9% in 1929 to 28.4% in 1958. Thus, a mixed
economic system is one in which both public and private sectors play an important role.
The two sectors coordinate with each other in the decision-making process covering
economic activities in general and resource allocation in particular. Shonfield (1984)
describes a mixed economy as “A mixed economy is one in which prices and supplies of
goods and services are largely determined by market processes. At the same time, the
state and its agencies have a large capacity for economic intervention, which is used in an
endeavor to secure objectives that the market would, it is believed, not achieve
automatically or not fast enough to meet the requirements of public policy.” In simple
terms, it is a system where market forces and government regulations simultaneously
operate in the spheres of production, consumption, and distribution.
Before, discussing further, it is essential to distinguish between institutions classified as
the government from the private ones. The individuals running the government
institutions are elected through a voting process or are appointed by the ones elected,
whereas the individuals running a private institution are chosen by the shareholders or are
self-nominated. They lack the right of compulsion, which a government is endowed with.
The government can force its citizens to pay taxes, can seize properties, and restrict
production and so on whereas all private exchanges are voluntary.
As we know, the public and the private sector are the vital elements of a mixed economy.
Coordination between the two determines the success of an economy. The public sector is
composed of enterprises, which are owned and controlled by the government. Such entity
includes institutions such as hospitals, government run schools, state offices, defense,
local and state government management and their departments etc. They engage in the
production, delivery and allocation of goods and services by and for the government or
its citizens, whether national, regional or local/municipal with the aim of maximizing
social welfare.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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On the other hand, the private sector is composed of private organizations that are not
owned and controlled by the government and run for private profits. All small businesses,
corporations, profit and non-profit organizations etc. constitute the private sector.

4. Role of government in a mixed economy

Markets are not able to achieve economic efficiency in all economic activities all the
time. There is some dissatisfaction with the way markets operate. Such problems are
classified as market failures – the inability of markets to achieve Pareto optimal
outcomes.
Weaknesses associated with the market system-
 Failure of competition where a single or few firms dominate markets can result in
undesirable consequences such as higher prices, less than socially optimal output,
fewer choices and compromise on quality etc.
 Another weakness associated with a market economy is that it cannot protect
individuals such as the elderly, disabled who lack adequate ability, knowledge
and are less informed to make informed rational decisions. Information required
to assess the products can be costly, technical and time-consuming to acquire and
evaluate. For example, there is a lack of an organized system to ensure that
products offered for sale are genuine and safe such as chemicals.
 The externalities associated with production and consumption activities of
individuals can result in significant cost for the third parties. The profit driven and
cost minimizing efforts of businesses can lead to significant external cost for the
society, for example, environmental degradation caused due to a power plant in a
locality.
 Market failures are also an outcome of age, gender and race discrimination of
workers resulting in unequal treatment and inefficient use of labor resources.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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A market economy left to operate itself can lead to inequality in income distribution on
one hand and promote monopolistic tendencies on the other hand. Moreover, such
economies are prone to widespread economic fluctuations unless regulated. Growing
industrialization and urbanization, with large benefits, brings with them a host of
economic and social problems and builds pressure on scarce economic resources. The
problems associated with the provision of health, education, housing, social security and
other social-economic infrastructure are counterparts of rapid industrialization. Economic
development also calls for the development of other sectors such as agriculture. Very
often, a market economy system, especially in an underdeveloped country neglects the
growth of its agriculture and other indigenous sectors. Such problems can be effectively
tackled only through the intervention of local and state government agencies.
Another factor, which distinguishes a mixed economy from a market economy, is the
incorporation of planning in the development process. Planning is important in the case
of underdeveloped and developing economies suffering from lack of productive
investment and infrastructure. Most part of the savings is channelized into unproductive
activities such as jewelry and real estate. Hence, the public sector can act as a catalyst in
mobilizing such savings into productive uses.

Thus, government intervention is required to address an economy’s market failure and to

compensate for the lack of private sector initiatives. With government intervention, an
economy moves from the status of a pure market economy to a ‘mixed economy’.
Government alters the private sector behavior through the legal system and regulations,
taxes and subsidies, through lending activity and through publicly provided services. The
government influences the decision-making process through some general ways such as-
 Establishment of a legal framework-– property rights, contracts, court procedures
and other matters guide how businesses and households operate.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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 Government regulation– the government intervenes in the business decisions

through regulations on pricing, profit and other managerial decisions to address
problems such as pollution, availability, product safety etc.
 The government intervenes in the labor market to ensure workers’ rights and
protect their interests.
 The revenue and expenditure policies of the government impact the economic
activities of a country. These policies exert significant influence on employment
and inflation conditions. For example, an expansionary fiscal policy during
periods of an economic downturn can help boost the aggregate demand and
employment in an economy. The expenditure policies also have a direct impact on
certain industries and markets such as defense.
 The government also engages in social security programs such as income and
employment support programs. Such programs help to improve the employment
and earning potential of individuals and boost the supply of skilled labor force.

Overall, as pointed out by Shonfield (1965), there are five aspects of government’s role in
a mixed economy-
 Government’s influence on the management of economic systems has vastly
increased. This operates differently among countries; in some countries the
banking system plays a decisive role, whereas in some other countries public
enterprises exert an important influence on economic activities.
 Second, increasing public expenditure is incurred on public welfare or in
Keynesian demand management.
 Third, government’s regulatory measures such as property rights, quotas,
contracts etc. regulate the market functioning and encouragement of long-range
collaboration between firms.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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 Fourth, government economic policy includes an active industrial policy to

promote small-scale industries, promote research and development, boost exports
and the training of workers.
 And finally, governments are open to long-range national planning, both in the
public and in the private sector.
Shonfield (1984) highlights the objective of government intervention,
“The ‘degree of mixedness’ is not determined by the size of the public
sector or the proportion of public expenditure to the national income. It is
the function adopted by the state rather than its mass, which counts.
Governments and their agencies intervene either to accelerate a market
process, or to delay it, or to bias the market in a certain direction by means
of subsidies or taxes or by direct regulation. States attempt to reduce the
losses of output and welfare which are caused by fluctuations in private
business sentiment and activity.”
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.

There is no doubt that price mechanism cannot assure microeconomic efficiency and has
often led to high unemployment and economic instability. Hence, government

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
____________________________________________________________________________________________________

intervention has become an important component for correcting market failure and for
ensuring economic stability. It can supplement the private sector and act as an agent of
economic development. The public sector assumes even more importance in
underdeveloped and developing economies that lack adequate resources, suffer from
widespread poverty and unemployment.

And following are some important features that highlight the role of government in a
mixed economy-
1. The simultaneous existence of and Coordination between the Public and the
Private Sectors.
2. Allocation of Resources through the price-mechanism and government directives.
3. Protection of Consumers choice and their sovereignty.
4. The arrangement of definite economic planning for the Public Sector enterprises.
5. Government intervenes and regulates profits of the private sector.
6. Promotion and ensuring Social Welfare of the citizens.
7. Implementing the effective fiscal policy and monetary policy conducive to
economic development.
8. Encouraging technological progress to promote efficiency in the economy.

The government participates in a mixed economy through various measures such as:
 Direct participation
 Regulatory or Indirect measures
 Direct physical controls
Direct Participation
The government directly participates in many economic and social sectors. For example,
in India, the industrial policy of 1956 gave government monopoly over major industries.
The Indian government still continues to enjoy exclusive control over sectors such as

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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railways, defence, and atomic energy etc. The government exclusively performs
economic activities such as those targeted towards poverty reduction.

Regulatory or Indirect measures

The government can resort to indirect measures such as taxes, subsidies, tariffs etc. to
achieve the planned targets. For example, the government can resort to higher import
duties to curb imports, restrict money supply during periods of inflation through the
central bank’s intervention etc. It can also resort to regulatory measures to control the
private sector so as to achieve desired social- economic objectives.

Direct Physical control

The government can resort to direct physical control measures such as quotas, licensing
and other rationing system to direct allocation of resources. Such measures are adopted in
situations where government does not want to directly enter or when regulatory measures
fail. For example, export restrictions in event of the scarcity falls under the category of
direct physical controls.

Role of government in Under-developed economies

Government intervention in the form of public sector activities is inevitable in the case of
underdeveloped countries that suffer from economic rigidities and a vicious circle of
poverty and underdevelopment and where market failure may be even more severe. This
vicious circle can be broken through comprehensive government planning.
The process of economic development is held up in the early stages due to lack of
economic and social infrastructure such as health facilities, education, highways, telecom
etc. in under-developed countries. Provision of such social overheads will create external
economies for expansion of the private sector. However, there is a lack of private
initiative in the provision of such overheads because it requires huge capital outlays, long
gestation period and low and uncertain returns. Moreover, return accrues in the form of

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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say high standards of education, an organized transportation network etc. which accrue to
the society as a whole rather than to individually to a private investor who undertook
investment in the creation of such infrastructure. Hence, private investors find such
expenditures not highly profitable and as a result, there is a lack of private investment in
such areas. The private sector lacks the capacity and necessary approach for undertaking
such development initiatives. This necessitates direct government intervention. The
government can raise the necessary resources for building such infrastructure through
modes of taxation, public debt and deficit financing.
Another area where undeveloped countries suffer is the lack of resources and adequate
skills. The markets, as we know, cannot allocate all resources efficiently all the time.
They suffer from both incentive and information constraints. Thus, the government
through planning and scheme of priorities can lead to efficient allocation of scarce
resources. Besides, the private sector in these countries lack attention to the long run
problems and objectives of the economy and rather concentrates on short term profit
objectives, are unprepared and reluctant to invest in social projects, suffer from
uncoordinated economic decisions among various sectors of the economy.

Importance of the Public sector

The problems associated with the functioning of the price mechanism are a strong
rationale for the growth of the public sector. An efficient and effective coordination
between the public and the private sector is an imperative requirement for the
development process. The public sector has three important roles to play-
• Compensatory or substitutive role: The need for public sector arises when there is
a need to compensate for the deficiency of the market system. It can substitute for the
private sector and perform corrective productive and distributive activities and at the
same time ensure efficient utilization of scarce resources. For example, the power sector,
exclusively, in the hands of the private sector is prone to monopolistic tendencies or
externalities. The control of government, through regulations, over the power sector is the

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
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remedy for such situation. The public sector also makes up for the deficiencies of the
market system in the achievement of socially desirable objectives such as those
concerning health and education. The private provision of such services has been often
inadequate and inequitably distributed.
• The adjunctive role: The public sector plays an adjunctive role in the provision of
public and merit goods. The market fails in the assessment of true preferences of the
individuals for goods satisfying social wants and thus does not provide such goods.
• The Competitive role: The public sector plays a competitive role in provision of
merit goods in order to keep the private sector’s monopolistic tendencies in check. The
government either directly provides these goods or subsidizes the private sector provision
of these goods.

Overall, the success of all these governmental efforts depends upon the administrative
competence of the government. It should aim for an environment conducive to the
efficient functioning and coordination between various players of the market system.
Creation of a right incentive and information structure for the private sector will attract
the right amount and quality of private investments. In poor economies, it should take
care of crucial activities such as health, education, and infrastructure and ought to be
active in the fields of social security and at the same time should refrain from activities
where the market system is already efficient.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
____________________________________________________________________________________________________

5. Summary

 The Market is a system that coordinates the production and consumption of goods
and services through a price mechanism.
 The government is an organization that uses coercive force to coordinate people’s
activities according to set rules and regulations. It takes responsibility for
provision of goods and services that cannot be provided by the markets such as
public goods, social security etc.
 The Great Depression saw the rise of government spending on economic and
social activities. The Keynesian school of thought advocated a greater role of
government in economic activities and pushed for greater fiscal measures for
promoting economic growth. Thus, gradually market economies such as US
moved to a mixed economic system with a greater role of the government.
 Government intervention in a market economy is required to improve
microeconomic efficiency by correcting a market failure.
 A mixed economy is a system where market forces and government regulations
simultaneously operate in the spheres of production, consumption, and
distribution. The public and the private sectors coordinate with each other in
decision-making process covering economic activities in general and resource
allocation in particular.
 The government participates in a mixed economy through various measures such
as direct participation, regulatory or indirect measures and direct physical
controls.
 The public sector is composed of enterprises, which are owned and controlled by
the government. Such entity includes institutions such as hospitals, government

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector
____________________________________________________________________________________________________

run schools, state offices, defense, local and state government management and
their departments etc. They engage in the production, delivery and allocation of
goods and services by and for the government or its citizens, whether national,
regional or local/municipal with the aim of maximizing social welfare.
 The private sector is composed of private organizations that are not owned and
controlled by the government and are run for private profits. All small businesses,
corporations, profit and non-profit organizations etc. constitute the private sector.

ECONOMICS Paper 7: Theory of Public Finance

Module 3: Role of government in a mixed economy – public and private
sector