Module: Governance

Assignment:‘The role of the government is to compensate for market failure.’ How accurately this captures the role of Government in India.

Market failure in India
India on attaining independence in 1947 inherited a backward economy. India had minimal infrastructure in transport, power, commercial banking, heavy industry, and communications. Agriculture and industry had ordinary investments. There were only a few participants and modest resources in the market. These resources and investments were unequally distributed. The market did not have enough competition and ‘allocative efficiency’. Olson (1986) points out that ‘whenever there is a Pareto sub-optimal allocation of resources, it results in a market failure.’ The government thus concluded that there existed a ‘market failure’ of investment and infrastructure in most sectors in the market. To compensate for these ‘market failures’ the government initiated a process of compensation by making huge investments in the public sector. (Dutta-Chaudhari, 1990)

Role of the Government
The government in India followed a path of ‘developmental economics’ in which the government took a leading role in investment allocation, economy control and wealth distribution. (Dutta-Chaudhari, 1990) It intervened in the areas of Public goods (Roads, Infrastructure and Public Health), Quasi-public goods (Irrigation, Waterways, Electricity, Agriculture and Education) and Private goods & services (Telecom, Ports, Airports, Tourism, Hotels, Airlines, Heavy Industry). (Virmani 2004) The government believed that if physical capacity was created, production, productivity and growth would follow and these in turn would compensate for the market failure. The ‘theory of market failure’ was used by the government to justify the production of all kinds of goods and services. (Virmani 2006) In 1960s and 1970s, economic activity was carried through the government public sector enterprises. This created government dominance in railways, telecom, electricity, ports and communication. All types of markets were run either by the government or sheltered by way of imposition of tariffs and barriers. The government also controlled market dynamics through quotas, permits and licenses.

This role of the government in the markets was justified by Bator (1958) who argued that, ‘the undersupply of goods and existence of market failures serve as standard justifications of possible governmental role in private economy.’ Similarly, Nelson (1987) in his theory on normative form of government argues that, ‘whenever there is market failure, it is the role of the government to intervene in the market to restore equilibrium’. Thus, an economic argument existed which supported government intervention in markets, which did not efficiently distribute goods and resources. On the other hand, Buchanan (2003) argues that this archetype was merely a socialist ideology backed by the theory of welfare economics, which presumes that politicised corrections for market failures would work perfectly. Shepsle & Weingast (1984) also caution against this interventionist approach and point out that, ‘it remains to be seen if the political solutions…entail efficiency gains or they exacerbate market failures.’

Market compensation through Public sector
Let us now examine the governmental approach in compensating for the market failure and the result of its intervention. The government made significant investments in the public sector and attempted to compensate for market failure through these enterprises. Public sector enlarged its role in most market spheres. The public sector had poor quality and outdated technology, which only partly fulfilled the market demand of goods. The gap in demand caused black marketing and profiteering. To rectify this non-performance government brought in a number of administrative and legislative public sector policies. These policies were to, ‘assign roles to public sector to compensate for its inadequacies in the market’. (Wolf 1979) The public sector however, continued to engage in the market, as a commercially unviable business. It had no incentive or disincentive for being efficient and cost-minimal. The government activity continued to focus on protection of the market and production through inefficient public sector, which resulted in low returns on heavy investments.

Rent seeking private sector
A few private industries, which developed, became ‘rent seekers’ (Tullock 1967) and sought government safeguards to thrive. This was because ‘whenever government grants rights or provides tariff protection, the beneficiaries seek for continuation of this rent seeking behavior.’ (Buchanan 1986) They took insignificant initiatives to develop new technologies or create economies of scale. But, governmental involvement in market economy exceeded its ability to achieve constructive results. The governmental attempt to regulate caused a ‘regulatory capture’ by those being protected. This also resulted in ‘allocative inefficiency’ and ‘x-inefficiency.’ (Grande 1991) Thus, government compensation for the market failure created an abnormal situation. It did not resolve the problems of market failure but created fresh problems. The ‘government compensation in the markets, which should have brought efficiency and equity in the markets, in reality, caused low efficiency, no equity gains and created a new inequity.’ (Virmani 2005)

‘Government Failure’The theory of applied economics supports the paradigm that ‘competitive markets’ present the most ‘efficient allocation’ in the economy as they lead to ‘Pareto optimal allocation of resources.’ Cordes (1997) in discussing various theories of role of government argues that the ‘utilitarian theory’ supports the idea that the government should intervene whenever this efficiency is absent. Krueger (1990) however points out that, the government by its time-to-time interventions is unsuccessful in developing a pareto-optimal situation in the markets. Government involvement causes greater deviations in efficient use of resources than the market forces. This ‘neo- classical theory’ of political economy, draws attention to ‘government failure’ for its insufficiency in compensating for a ‘market failure.’ This argument has been further supported by Stiglitz (1989) who emphasizes that, ‘the fact that markets face certain problems does not in itself justify government intervention…the government is likely to face similar problems if it intervenes.’

Indian market, because of government intervention became unproductive, monopolistic and inefficient. This created economic inconsistencies. In early 1980s there were ‘distortions in the shape of loss making public sector enterprises, monopoly in public distribution, heavy industry and mines, deterioration in telecom, transport, health and education sectors and inefficiency in nationalized banking and insurance sectors. Whether market failure was there or not it was a colossal government failure.’ (Srinivasan, 1985) The failure of government role in market has also been emphasized by Virmani (2006) when he states that, ‘the government is neither omniscient (all knowing) nor omnipotent (all-powerful) nor omni-competent. Even with the best of intentions and motivations it can and does fail spectacularly.’ For the government it was hard to accept these shortcomings as a ‘government failure’ but in 1991, this ‘governmental failure’ landed India into an acute crisis of balance of payments. The government did not have money to pay for its imports. Gold reserves had to be physically mortgaged to Bank of Japan to borrow money to make payments for oil imports. Thus, the attempt by the government in India to ‘compensate for the market failure’ resulted in its ‘own failure’ in the market economy. This was an anti-climax to the compensatory role the government in the markets.

Dilemma of the role in the markets
The balance of payments crisis made the government realize that the market interventions had reached a dead-end. The processes, which had been set in place by the government, did not yield the desired outcomes and some drastic measures were needed. The role of government in the market needed reassessment. Chibber (1997) argues that, ‘many observers feel that the logical conclusion to be drawn from these failures is that the ideal state is the minimalist state.’ However, he also feels that based on the success stories of present and past, ‘A minimalist state would do no harm, but neither could it do much good.’ Nelson (1987) on role of government in such a scenario states, ‘there is no satisfactory normative theory regarding appropriate roles of government in a mixed economy.’ But, Chibber (1997) puts in another argument that, ‘transition economies and the mixed economies of the industrial world, in response to the failures of state intervention, are moving toward greater reliance on market mechanisms.’ Krishnakumar (2000) questions the government hesitation on changing its approach by stating, ‘The popular belief now is that if market failure was the rationale for government intervention, and the latter too could not deliver the goods, then why is there no movement back to the market.’ In this critical scenario, one thing was aptly clear that the governmental role warranted a fresh outlook. The government had to choose if it should continue to in the market place as a compensator or realize that it too had failed and revert to the market mechanism. The change in Government however solved the issue and the new government initiated a major reform process to move back to the market mechanism.

Market ReformsThe reforms initiated in 1991, ‘brought a system change, involving liberalization of government controls, a larger role for the private sector and greater integration with the world economy.’(Ahluwalia, 1999).These reforms included structural reforms including decontrol of private investment, opening up the economy to foreign trade and foreign investment, financial sector reforms, dismantling quantitative restrictions, reducing tariffs, reducing price controls. Reforms also included public sector reforms like disinvestment, diluting government stake allowing them to access to capital markets, reforming financial sector including Banking, Capital markets and Insurance. (Ahluwalia, 1999)

Government's role as facilitator in the market
The reforms brought a change in the role of the government in the markets and the through them the government sought, ‘to achieve, a well designed transition back to market based economy that aligned producers, consumers and the government.’ (Bhattacharya and Patel 2003) For the comeback of the market economy, the government realized that, ‘the key step in reducing the impact of excessive regulation was to reduce the degree of intervention in the economy.’ (Brahmananda 2004) To achieve this government dismantled several controls, licensing mechanisms, quantitative restrictions and developed the concept of single window clearance. It encouraged market through fast track approvals. The government in post-reform market economy changed from being a compensator to being a facilitator. It is now encouraging private investment by providing favorable environment for investment. Government is creating an environment for markets to establish and operate competitively. It is having mechanisms in place to prevent monopolies and distortions. It is no longer making investments through public sector or restricting the operations of market economy but is now focusing on a policy framework to enable production & regulation. It is providing an independent professional regulatory system to promote competition & minimize regulatory costs. The market forces are controlling the dynamics in the market place and government is helping in creating and regulating the markets. The rent seeking behavior of permits, permissions and quotas has been essentially discarded. The results and vibrancy of reforms indicate a trend in this direction.

Government role is not yet overThe government in 1990s and 2000s allowed the market forces to operate in software and information technology sector. It did not enter these areas and market forces sustained the growth. The government acted as regulator by having level playing field and introducing enabling legislation. This resulted in unprecedented growth in software, information technology and communications. India is now a force to reckon with in these areas. (Trivedi 2006) Other areas like telecom, banking, insurance, infrastructure and airports are showing tremendous results. The liberalization measures due to deregulation and decontrol, increased competition have encouraged private entrepreneurs to be more responsive to the price signals in the markets. This has helped improve efficiency in resource use. (Emran, et al, 2003) But, there are areas where there exists significant market and government failure. In agriculture sector, it is still uneconomical for the market to provide equity and investment. In the field of education and health, the market has seen lopsided development of knowledge and capacity. The government role has not ended in these areas. ‘The government being the natural principal in this sphere has to step-in and compensate in these areas.’ (Krishnakumar 2000) The government is therefore enhancing its own capabilities in these fields. It is also promoting private enterprise to perform in these areas and wherever possible combining the benefits of public and private economies through public private partnerships. The government is also making investments that are focused on public & quasi-public goods for a high social equity and is therefore is trying to establish critical infrastructure of roads, railways, ports and airports to support production and economic activity. (Bhattacharya and Patel 2003)

A new role for the Government
Although the government has moved away from performing a compensatory role in the market but it has still major role to play, which is, to act as an effective regulator in the market. As underlined by Bhattacharya and Patel (2004) that, ‘government monopoly power can be mitigated through effective regulation’ and any new market failure will not happen because of the ‘flawed government ownership’ but because of ‘private ownership operating underneath a potentially flawed regulatory structure.’ Thus, government role as an effective regulator is very important and as a regulator, government is trying to create a level playing field and generate healthy competition. (Morris 2002) It is also attempting to bring more players in the market as ‘the best regulation is through competition.’ (Brahmananda 2004) The government wants to assure competition so that there are no inefficiencies and non- accountability in these sectors. Government ‘does not want to fail twice, initially in not allowing the market to develop and now as the market is developing by not regulating enough.’ (Sharma, 2001)

Apart from being a regulator, the government is also performing another role, which is making certain that ‘property rights are identified clearly and institutions are in place to ensure their proper allocation.’ (Davidson and Weersink 1998) This is assisting the creation new markets as it is lowering the ‘transaction costs’ and ‘strengthening the faith of the players in the market in the public exchange.’ (Zerbe and McCurdy 1999)

Conclusion:
The role of the government has progressed as the economic theories have evolved. The original normative theory on the role for ‘governmental intervention in case of a market failure’ has been replaced by the neo-classical theory of ‘government failure.’ This is evidenced in India, by governmental role in market failure. The government initially began, as an active ‘compensatory agent’ for the failure of the market mechanism. It was however, unsuccessful in compensating for the failure and governmental intervention created distortion in the market. The government did not have sufficient means to outdo its own inefficiency and bring efficiency in the market. Therefore, in my opinion the role of the government is not to compensate for the market failure. In fact, government is not the ideal compensator for a market failure, as it does not have the capacity to do it successfully and such intervention only results in governmental failure.

The new economic paradigm of reversion to the markets after government failure has lead to reforms in India and the start of a new economic process. Under the reform process, the government has reverted to market mechanisms for equity and efficiency. The government role has now evolved to another level. From being, a compensator in the market the government now has the role of an impartial regulator. As a regulator, government prevents distortions and inequity, controls rent-seeking behavior and corrupt practices, in the market and ensures its smooth functioning. It facilitates growth and provides opportunities. The government also plays the role of a catalyst by allowing both the private enterprise and the individuals to perform. The government role has not ended. It is an ongoing process. The government has to continue to create suitable environment for economic growth and check on its own predatory growth. The Government has to combine the benefits of public and private economies through public private partnerships. It has to reduce unnecessary intervention and complement the role of public and private enterprise.

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