In this article we will analyse two alternative economic systems in order to ascertain which the most appropriate one to promote economic development is. An economic system is essen­tially an institution through which competition among people for using a society’s scarce re­sources is coordinated.

Economic Functions of the Market and State:

The market:

It is an institution comprised of rules for controlling voluntary transactions under the parameter of prices.

The state:


In contrast, the state is an institution consisting of a set of rules for governance.

A market is the organisation that coordinates the production and consumption of goods and services through voluntary transactions. By definition, transactions in the market are voluntary, based upon the free will of buyers and sellers. The market is, therefore, the organisation to coordinate people’s activities in seeking self-interest towards increasing social and economic welfare.

In contrast, the state is an organisation for monopolizing its coercive power. By using this power, the state coordinates people’s activities according to its own fixed set of rules and regulations. As part of those rules, the state enforces consumption of resources through such measures as taxation and military power, irrespective of an individual’s will, while taking responsibility for providing such public goods as national defence, police and roads which cannot be supplied by the market.


In spite of their exactly opposite roles in resource allocations, the market and the state are in-separately linked with each other. Thus, the two systems are interdependent. In this con­text we refer to the importance of clearly defining and strongly enforcing private property rights.

(i) Protection of Private Property Rights:


The first precondition for the smooth functioning of the market is a clear assignment of prop­erty rights on goods and services. By resolving conflicts on contracts between sellers and buy­ers, the state can greatly improve the efficiency in market transactions.

The state protects pri­vate property rights and enforces contracts by passing and enforcing laws through such organi­sations as courts and police. On the other hand, activities of state organisations are heavily dependent on the market.

(ii) The State’s Dependence on the Market:

The state has the authority to conscript resources for its activities. However, the cost of govern­ance would be extremely high if the state forced people to work against their will and procured innumerable goods and services necessary for its activities by coercion. Normally, the state purchases necessary goods and services from the market from its tax revenue.

Just a Matter of Degree:

In truth, no modern progressive economy can function without the state and the market. Eco­nomic systems differ due to difference in the way in which the state and the market are com­bined, i.e., which aspects of economic activities the state is in charge of, which aspects are left to the market and strongly and widely market activities are controlled by the state. It is just a matter of degree.


The pertinent question here is what combination of these two organisations would optimize the growth of developing countries like India. The answer to the question depends on the merits and demerits of the two systems — the market and the state.

Efficiency of the Competitive Market:

Both classical and neo-classical economists sang the praise of the free competitive market which, they believed, results in a socially optimum allocation of resources. The market system is essentially a mechanism to equate demand and supply of a commod­ity (or service) through adjustments in its price.

Obviously, a free market has the power to establish a single price. In the same way, the market system operates in adjusting the price to equate demand and supply of the commodity.

This neo-classical type of equilibrium between demand and supply through transactions in a free competitive market represents an efficient resource allocation for the production of a commodity to maximise economic welfare in society. This is because no market participant (buyer or seller) can increase his welfare without decreasing that of the other — the so-called ‘Pareto optimality’.

Market Failure:

The market system functioned quite smoothly in the wonderful world of Adam Smith. Adam Smith’s invisible hand mechanism worked fairly well for more than one and half century (1776- 1929). And the society was moving towards a distant but clearly visible goal (welfare maximisation). However, the Great Depression of 1929 which lasted for about four years (1929- 33) years made it clear that the invisible hand of the market had to be replaced, at least partly, by the visible hand of the government.

And in 1936 Keynes argued that just as the central bank is the lender of the last resort, the government is the employer of the last resort. This means that when the private sector cannot create jobs and incomes the government should come forward to add to total expenditure and enable a depressed economy to re-achieve full employment. The great crash of 1929 first brought into focus the weakness of the market now known as the market failure.

If the market can achieve a socially desirable allocation of resources, there would be no need for government to coercively intervene in economic activities such as production, distri­bution, exchange, consumption and investment. However, the market is not able to achieve optimality in all economic activities. Any divergence of market equilibrium from the point of Pareto optimality is called market failure. The government is supposed to ensure an optimal correction of market failure.

(i) Public Goods:

Prima facie, market failure arises in the supply of public goods. The market can achieve effi­cient allocation of resources only in case of private goods for which private property rights are well established. In case of private goods it is possible to apply the exclusion principle. Only those who are assigned rights are entitled to the goods.


Others have to pay for using such goods. However, as for police protection, street lighting, national defence and basic scientific knowledge generated from research founded by the government, any number of people can use them jointly (nonrivalness). And it is difficult to impose appropriate payments on users (non- excludability).

Everyone seeks to use and enjoy such ‘public goods’, without sharing the cost (free-riders problem). Since a profit-seeking firm has hardly any incentive to supply such goods (for which it cannot charge the users directly in the form of prices and indirectly in the form of taxes) the government alone is able to supply such goods to all people indiscriminately. The reason is that the government covers the cost of supplying such goods through taxes and the government alone has the taxing power.

(ii) Public Bads:

Market failure also arises from public bads. Automobiles, for instance, are, no doubt, private goods. But they pollute the environment and may be treated as ‘public bads’. So actual produc­tion of automobiles exceeds the socially desirable level because the private producers do not take into account the external costs that they impose on other members of society. The govern­ment can fix the level of automobile pollution through quantitative restraint (i.e., by fixing production quota) or anti-pollution tax and thus ensure a correction of market failure.

(iii) Imperfect Information:

Market failure can also occur in case of pure private goods. The market mechanism achieves social responsibility when the most important condition of perfect competition is satisfied, i.e., all the buyers and sellers have perfect information on the prices and the qualities of commodi­ties and no one can have monopolistic power to influence market prices.


In reality, however, information is imperfect. Due to large gaps in information between buyers and sellers, there is qualitative uncertainty. It is really difficult for most customers to judge the quality of professional services, such as those of doctors and lawyers. It is equally difficult to judge financial services from banks and insurance companies especially with respect to safety of deposit and insurance payment.

If buyers stand a chance of incurring losses from fraudulent sellers utilizing this ‘asymmetry of information’, then transactions in the market will be smaller than the socially desirable (Pareto-optimal) level, or may even totally disappear. In such cases of market failure, the government may have to intervene by limiting business permits and licences to qualified sellers for increasing the quality of information to buyers.

(iv) Regulation of Monopoly:

Where there is significant divergence of market equilibrium from social optimality due to monopolistic sellers or monopsonistic buyers, corrective actions in the form of anti-mo­nopoly laws—such as the MRTP Act—may be required.

Also, in some industries characterised by increasing return to scale, such as electricity or water supplies, local monopoly might be more efficient than competition. In such a situation, the government has to regu­late prices or undertake production by public corporations to avoid monopolistic pricing by sellers.

(v) Distribution of Incomes:


The government has also an important role to play in redistribution of incomes. Equity in income distribution as a social goal is as important as efficiency in production. There is no conflict between efficiency and equity in the true sense since maintenance of ‘fairness’ or ‘distributive justice’ is needed to enhance economic efficiency. The reason is that worsening of income distribution is a threat to social stability makes normal economic transactions more difficult and costly due to the growing incidence of crime and violence.

The market mechanism is, no doubt, for promoting economic efficiency but not to improve the pattern of income distribution. If the income distribution realised through the free market is not socially desirable, the government has to achieve this goal by using its coercive power. Two measures of income redistribution are income tax and social security. These government activities to correct market failures are a part of public goods. The reason is that they increase economic welfare.

Government Failure:

Government failure has two main sources:

(i) Inefficient Budget Allocation:

Government failure occurs when there is over-supply of a public good. The supply of public goods curtails costs which are ultimately borne through taxation. If a government activity to correct a market failure curtails higher budgetary cost less than the social gain from the corrective measure, it represents an oversupply of public goods.

Although a short supply of public goods represents a major bottleneck to the growth of developing countries, the government, as a bureaucratic organisation, has an inherent tendency to oversupply these public goods of relatively low social demand at the expense of those public goods vitally needed for economic development.

Budgetary allocations among various public goods are made on calculations of the strength of enhancing political support and not so much on considerations of their contribution to eco­nomic welfare of society. For this reason, a public good, such as basic scientific research, whose benefit to society far exceeds its cost, is often undersupplied.


Since its total benefit will be distributed widely among a large number of people in the future, hardly any strong pressure group is likely to be organised for such public goods. In contrast, construction of local road or bridge may be lobbied for very strongly. Such public infrastructure may be oversupplied if it is expected to produce a large profit for a few contractors and/or a small number of residents in a narrow local community.

Secondly, since the government is a monopolist of legitimate coercive power and has no danger of bankruptcy, it has an inherent tendency to expand its output size just for increasing the power and position of the bureaucrats.

Since the bureaucrats command a large body of information, which cannot be assessed by the masses, they can easily manipulate the informa­tion to inflate the value of public goods they want to supply (such as exaggerating the danger of national security to increase defence expenditure, and the size of armed force).

Furthermore, government organisations are normally found to be inefficient in the absence of profit incentive and any chance of bankruptcy. So the government has a tendency to over- supply unnecessary public goods.

Since bureaucrats and pressure groups often strongly resist any reduction in vested inter­ests, they do not want to reallocate limited budgetary resources from one category of public goods to another in response to changes in social needs and priorities.

As a consequence there is often an oversupply of unnecessary public goods, and an undersupply of public goods of high social priority. Such inefficient budget allocation which results in loss of net social wel­fare is called ‘government failure’.

(ii) Bias in Budget Allocation:


Government failure arises not only due to misuse of budget, but also from undue regulations to bias in resource allocations. There are various types of regulations that made positive contribu­tions to socially desirable goals such as pollution control and safety of public when they were first introduced, but later had socially negative effects.

For example, the compulsory regular checking of cars by authorised groups in Kolkata made a high social contribution towards the control of air pollution when automobiles made in India were low in quality. However, since the quality of cars has greatly improved over the years, this has become a system to protect the vested interests of the authorised groups at the expense of car users,

What is really troublesome is that government imposes more and more regulations when those with vested interests seek institutional rents or excess profits from regulations. Such rents are partly used for the sake of preserving the regulations. Firms protected by a regulation raise funds and use ballots to support politicians in exchange for their support on the preservation of this regulation.

It is also common for firms to appoint retired government officials who still have close contacts with the regulators and get things done through personal relations. Through rent-seeking activities by bureaucrats and politicians as well as protected firms, socially nega­tive regulations continue to be maintained and reinforced. In general, regulations are the source of corruption—defined as the use of public office for private gain.

On the Choice of Economic System:

Politicians and bureaucrats are agent for the citizens and should serve and promote the welfare of the nation. Yet they usually place high priorities on their own profit than on the peoples’ or even their own nations well-being. Such moral hazards are quite common in the agency contracts in the private sector, such as financial agents managing entrusted funds for their own profit and not for that of their customers.

This is also known as the principal-agent problem. In theory, moral hazards are not a serious issue if a principal can recognise the agent’s interest and action and discharge the agent before he causes moral hazards. In the real world—characterised by information asymmetry—however, moral hazards are a major source of market failure.


This problem is even more serious as a source of government failure. In principle, citizens should be able to discharge politicians and bureaucrats who commit moral hazards (through voting, rioting and revolution—both violent and peaceful). However, the quantum of informa­tion collected by government agencies for administrative purposes is usually much greater than that available to individual citizens.

It is fairly easy for politicians and bureaucrats to cover up their moral hazards, often in collusion with private firms under their patronage, by manipulating information over which they have monopoly. In contrast, the cost of detecting moral hazards in government agencies is usually very high for a lay person.

And his/her cost of transmitting this information to the majority of citizens and organising political campaigns against corruption and misconduct by government agencies is really prohibitive. Gains to the nation as a whole from his activities may be much larger than the cost he is likely to incur.

But these gains will be widely diffused among many persons, so that his own gain would be too small to cover the huge cost of infor­mation collection, discrimination and political campaign. It is, therefore, quite obvious that the activities to prevent moral hazards by government are much smaller than is socially desirable.

In contrast, political activities by small interest groups (like business people, traders and pro­fessionals) willing to indulge in institutional rent-seeking activities from socially negative con­trols and regulations are intensive and are likely to expand over time. For this reason social loss arising from government failure often far exceeds that from market failure.

A Case Example:

In reality it is difficult at times to draw a line between the two—market failure and government failure. The 1997 Financial Commission, South East Asia, illustrates this point. See Fig. 1.

Asian financial crisis

While the Great Depression of 1929-33 is a historical example of market failure, the col­lapse of socialism in 1989 is a glaring example of government failure. The economies suffering major damage were the ones that maintained a fixed exchange rate under the capital account.

The financial crisis in East Asia clearly shows that government failure under a regulated capital account could be has serious as market failure under the liberalised capital account. The financial crisis, caused by huge investment boom, could have been avoided if the government adopted means to reduce demand before the economy became overheated.

Financial policies to control domestic money supply and interest rates are not effective in controlling domestic de­mand if there is no regulation of international capital movement under the fixed exchange rate system. In such a situation fiscal policy in the form of cut in government expenditure is not politically feasible unless and until the economy becomes really overheated.

The Asian financial crisis is an example of market failure resulting from imperfect informa­tion in the international capital market. It is also an example of government failure. It occurred due to failure of the government to provide appropriate prudent supervision and regulation of risky transactions in the international financial market.

It occurred due to the failure of the government in fulfilling its basis mandate, i.e., the provision of appropriate public goods. Yet the fact remains that profit-seeking private agents, misguided by imperfect information, were directly responsible for creating the crisis in East Asia.

Complimentary Role of the Market and the State:

Both the market and the state are indispensable for allocating resources. The main criteria to be used in choosing an economic system is to find the appropriate mix of market and state by clearly recognising the possible failures of these two organisations. For developing countries the types and magnitudes of both market and government failures depend on the stages of development.

In general, the less developed the economies are, the more imperfect the infor­mation is, and the less organised the institutions are for supporting the market (such as protection of private property rights). In such economies, market failures assume serious proportions. So, there is need for strong government action to correct them.

However, in these LDCs, the educa­tional levels of the people is low and mass media for public opinion formation is underdeveloped. For these two reasons there is not much participation of people in political matters. Under such social conditions government failure is much more serious problem than market failure.

So the choice of an optimum combination of the market and the state is of paramount impor­tance in formulating the design and influencing the pattern of development.

In recent years, the IMF and the World Bank have been deeply concerned with poverty reduction in LDCs while at the same time stimulating growth by providing structural adjustment assistance. This calls for effective implementation of the strategy of redistribution with growth i.e., faster growth and greater distributive justice. No doubt market competition is a strong instrument for increasing economic efficiency but not for improving equity.

For poverty alleviation, non-market instruments may have to be used to redistribute market-produced income in favour of the poor. Moreover, poverty is not just a receipt of a less than socially allocated minimum subsistence income, but also a restriction in human capability. Therefore, social services such as education, health and social safety nets must be delivered to the poor by the government.

In the past two decades most LDCs have introduced economic reforms at the insistence of the IMF. Reforms in such countries have sought to reduce government control and intervention. However, this is a step in the right direction since the neglect of indirect effect is the common source of all fallacies.

This is because market failures arising from such reforms will be very large where the market is highly imperfect due to imperfect information. However, in the economics characterised by high degrees of information imperfection, government failures may be even more serious and damaging than market failure.