THE ROLE OF GOVERNMENT IN AN ECONOMIC SYSTEM
- We shall first consider why an economic system should be in place. The basic economic problem of scarcity arises from the fact that on account of qualitative as well as quantitative constraints, the resources available to any society cannot produce all economic goods and services that its members desire to have.
- Therefore, an economic system should exist to answer the basic questions such as what, how and for whom to produce and how much resources should be set apart to ensure growth of productive capacity. The modern society, in general, offers three alternate economic systems through which the decisions of resource reallocation may be made namely, the market, the government and a mixed system where both markets and governments simultaneously determine resource allocation.
- Adam Smith is often described as a bold advocate of free markets and minimal governmental activity. However, Smith saw an important resource allocation role for government when he underlined the role of government in national defence, maintenance of justice and the rule of law, establishment and maintenance of highly beneficial public institutions and public works which the market may fail to produce on account of lack of sufficient profits.
- Since the 1930s, more specifically as a consequence of the great depression, the state’s role in the economy has been distinctly gaining in importance and therefore, the traditional functions of the state as described above, have been supplemented with what is referred to as economic functions (also called fiscal functions or public finance function).
- While there are differences among different countries in respect to the nature and extent of government intervention in economies, all governments are still expected to play a major role. This comes out of the belief that government intervention will invariably influence the performance of the economy in a positive way.
- Richard Musgrave, in his classic treatise ‘The Theory of Public Finance’ (1959), introduced the three branch taxonomy of the role of government in a market economy. Musgrave believed that, for conceptual purposes, the functions of government are to be separated into three, namely, resource allocation, (efficiency), income redistribution (fairness) and macroeconomic stabilization. The allocation and distribution functions are primarily microeconomic functions, while stabilization is a macroeconomic function.
- The allocation function aims to correct the sources of inefficiency in the economic system while the distribution role ensures that the distribution of wealth and income is fair. Monetary and fiscal policy, the problems of macroeconomic stability, maintenance of high levels of employment and price stability etc fall under the stabilization function. We shall now discuss in detail this conceptual three function framework of the responsibilities of the government.
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