Economic Rational of the modern state

1. THE ECONOMIC RATIONALE
OF THE MODERN STATE
(continued)

2. The Distributive Role Of Government
• Apart from Allocative efficiency of markets, economists
are also concerned with the distribution of income and
welfare between individuals and households, etc.
• Recall from the analysis of the market that underlying
each Pareto-efficient allocation there is a particular
distribution of initial endowments.
• The distribution of wealth depends upon the distribution
of rights to inherited wealth and the accumulation of
wealth over the individual's lifetime, and the distribution
of earnings will depend upon the initial distribution of
skills, subsequent training and the market price of these
skills.

3. • The resulting distribution of income, wealth and welfare
may not be in accordance with what society considers
to be just.
• The source of this injustice might lie in the original
distribution of endowments, or it might be due to the way
in which the prices at which the endowments are valued
are established.
• Factor endowments may be priced in perfectly
competitive markets or in imperfect markets. In either
case the resultant distribution of income might not be
acceptable

4. How Society Decides
• The problem that faces society is to decide which particular
distribution of incomes and welfare it prefers and then to
consider alternative measures which will take it from its
existing distribution to its most preferred.
• Establishing the most preferred distribution is obviously a
complex problem. For our present purposes, we want to
know is whether or not there is a role for government in
bringing about the most preferred distribution of income.

5. Role Of Government In Distribution
• Government is in a better position to pursue a coordinated
and comprehensive redistribution policy, because it has
the resources of compulsory taxation and better placed to
redistribute incomes on a large scale.
• Additionally, government can correct problems of income
distribution that arise from imperfections in the factor
markets, e.g. monopoly pricing of factors of production

6. Role Of Government In Distribution
• Government redistributes incomes and welfare by using
progressive taxes to finance cash benefits, subsidies and
also publicly provided goods and services. These goods are
either provided and financed completely out of taxation or
are provided at a subsidized price.
• It is unclear whether government's role should be to
provide such goods directly or for distributional
purposes, the government should provide income
supplements to individuals, thereby leaving them to
purchase from the market the quantity and quality of
services that satisfies their preferences.

7. Arguments Against Income Supplement
• First, that individuals, if given the freedom, are unlikely to
choose the most appropriate amount of, say, education or
health care.
• Second, government would prefer to have some direct
control over the quality and price of these services because
they are so important to general welfare.
• These two arguments represent the case that Musgrave
made out for the government providing 'merit goods' via
the budget. However, the reader should be aware that the
debate between the direct provision of 'merit type' goods
vs. the provision of income supplements is by no means
settled and constitutes an interesting problem in the
formation of an optimal social policy.

8. The Regulatory Role of Government
• The regulatory role of government was touched upon when
we considered government's Allocative role. It was seen that
government could attempt to regulate the decisions of
producers and consumers, thereby reducing monopoly
elements and externalities.
• But there are other instances where government has to
regulate behaviour of producers in order to protect
consumers.

9. • The immediate answer is that there are, for the individual
consumer, high costs of obtaining and interpreting
information relating to product safety and design.
• Thus government sets up a system of regulation and
control which will produce such information either
directly or indirectly.
• On other hand individual might not be capable of
protecting himself in the sense that he does not have the
resources at his disposal to establish and to police
minimum standards.
Why can‘t Consumers Protect Themselves/Why
Do We Have Governments Performing This
Task?

10. • Regulation limits the discretion and freedom of
individuals through the imposition of rules. Public
regulation refers to the implementation of rules by an
administrative agency that is backed up by law. This
contrasts with a system of self-regulation in which rules
are imposed voluntarily and backed up by an informal
code of practice rather than law.
• Why is it necessary to regulate?
Schumpeter argued that the capitalist system would
produce a social order which most would find hostile and
would wish to regulate. Regulation exists to protect the
"public interest' against the dysfunction of certain
unregulated market outcomes, e.g. the irrationality and
selfishness of free market capitalism.

11. • Some have argued that regulation amounts to the
replacement of the 'invisible hand' by an 'indivisible fist‘
• Controls and restrictions are designed to increase the
welfare of certain groups within society by protecting their
interests.
• Government, therefore, intervenes and regulates the
Allocative process of the market by legislating against
monopolies, controlling trading arrangements, and
introducing legislation to protect the consumer from
fraud, to prevent the consumer‘s health being
damaged, to control the design of goods for the purpose
of safety, to regulate working conditions, and to
control commercial broad-casting, abortion; pornography,
and biological research.

12. • Moreover, the government regulates the money supply; the
prices of utilities and nationalized industries; and, through
prices and incomes policies, many of the Allocative
decisions in the economy.
• Regulations also impose costs on the economy. Apart from
the bureaucratic costs of administering the system
consumers and producers incur costs when conforming
to regulatory controls.
• The benefits of regulation have been compared to the
costs which, apart from the direct administrative and
implementation costs, include increases in uncertainty
and the delays in investment decisions

13. Whose Interests Do The Regulators Serve,
and Who Regulates The Regulators?
• Public-choice theorists such as Stigler and Peltzman
addressed these questions and produced the 'capture
theory' of regulation.
• Although regulatory agencies are notionally working in
the public interest, capture theory suggests that they have
been taken over by sectional interests, especially those of
big business. Stigler and Peltzman show that wealth is
transferred via regulation in the form of regulated prices
and entry restrictions.
• It is therefore in the interests of producers or the
beneficiaries of regulations to gain control of the
regulatory agencies

14. • Moreover, it is the larger firms that have the most to gain,
so it is they who have the greater incentive to obtain such
control. The smaller, disparate and less organized firms are
neglected.
• Whether or not individuals and firms are willing to organize
themselves depends on the size of the gains from capture of
the regulatory agency relative to the transaction costs of
getting organized.
Is regulation efficient?
• This is a complex issue that depends on a number of factors.
First, regulated firms might make lower profits. Second, the
regulatory instruments often difficult to deal with
complex industrial structures. Third, surveillance becomes
routine and predictable with the result that resources are
allocated to evasion of the regulations.

15. The Stabilization Role Of Government
• The all forms of market failures refer to imperfections in
the structure of markets. Markets failed to produce a
Pareto-efficient outcome or an ethically acceptable
distribution of welfare. That kind of discussion is very
much the subject matter of microeconomics.
• The central idea in macroeconomics is the existence of self-
regulatory capabilities of a system of markets.
• In other words, are there automatic forces and
mechanisms within a market system which will move the
economy to a state in which all market excess demands and
supplies are zero? Does there exist a system whereby
economic activities are perfectly coordinated?

16. • In a macro context if economic activities are not sufficiently
well coordinated the result is a general disequilibrium,
which can show up in a number of possible ways, each
having an undesirable effect, e.g. the under-employment of
capital and labor, a rise in the general price level, or an
imbalance on the country's external trading account.
• The market failure in this case is frequently a failure of
communication between different economic agents
operating in different markets within the economic system.

17. • The failure of the market system to co-ordinate all activities
and to come into equilibrium provides the focal point for
macroeconomic policy.
• Government pursues a stabilization objective by using the
instruments of monetary and fiscal policy in an attempt to
aid the restoration of equilibrium.
• By pursuing money supply targets, adjusting tariffs or
exchange rates, and changing public expenditures, taxes and
interest rates, provide some of the conditions that are required
to bring the system into stability

18. • In addition to the short-term demand management policies,
outlined above, governments also co-ordinate the economic
decisions of the various groups in the private sector, in an
attempt to create the conditions necessary for sustained
long-term economic growth.

19. Governments and insurance
• Governments can provide an insurance function. Examples
include unemployment insurance, health insurance, and
insurance against being unable to work when you are old
(pension). In each case the individual is interested in
purchasing insurance against the outcome of some future
contingency.
• It is possible to purchase insurance against these
contingencies from the private market, but such markets are
usually imperfect and can discriminate against those in
greatest need.
• Government, therefore, supplies 'social insurance' (at a price)
partly as a means of overcoming the Allocative inefficiency
of the market failure and also partly as a redistributive
measure. As an exercise the reader should consider how
welfare is redistributed through the 'social insurance' system.

20. Political Economy
• A state of anarchy will result in a destruction of incentives
to invest, produce or trade. This is seen in the case of
piracy or in a country where the rule of law has broken
down completely.
• There exists, therefore, a strong incentive for the members
of any society to establish a social structure defined in part
by a set of property rights and civil rights and codified in
laws. The establishment and maintenance of this structure
(the rules of the game), which is a basic common pool
resource, requires the investment of some of society's
resources.

21. • Because at any moment there will be disagreement amongst
the members of society about the most just or fair
structure of society (distribution of rights), resources will
also be invested in activities designed to bring about changes
in the social structure. This view of society shared by
philosophers such as Hobbes and Locke.

22. What Determine The Original Distribution of Rights In Society?
• If the initial distribution of rights is 'unfair' then the final
distribution of welfare amongst individuals will also be
unfair even if it is produced by market forces. These are deep
issues over which philosophers are divided.
• Nozick (1974) tends to duck the question by simply arguing
that if voluntary exchanges are legitimate then the owners of
property are entitled to whatever is the outcome of these
exchanges. Rawls (1972) goes further and asks what welfare
distribution is necessary before individuals will wish to join
the society.

23. • Individuals will only be prepared to surrender sovereignty
to the state if there is an expectation of benefits from doing
so. They also require the rights and means of participating
in the activities of the state. Ultimately individuals must
ask how much inequality in society is to be tolerated.
• Even right-wing economists such as Hayek have argued
that there is 'no reason why in a free society government
should not assure to all protection against severe
deprivation in the form of an assured minimum income or a
floor below which one no one need descend' (Hayek 1976).

24. • Economists who are interested in institutions and policy
analysis focus attention on how rules structure exchange
relationships and guide self-interested behaviour.
• Public policy involves institutional changes, i.e. changing the
rules in response to new and evolving circumstances. The
neoclassical approach to institutional choice is to apply the
individual-maximizing calculus such that individuals choose
those rules that best serve their own interests.
• This ignores a major problem in public/social choice. When
each individual, or at least a significant number of
individuals, has diverse preferences for what
constitutes an ideal social structure, how are these diverse
preferences aggregated: how is the conflict resolved

25. • All political structures involve, simultaneously, a wealth
creating and a wealth impeding dimension.
• Different political structures have different mixes of these
effects. The 'protective state' defines private property rights
and other civil and human rights and arranges for the
protective arrangements of the police and the courts to
enforce privately negotiated contracts.
• Alongside the protective state there exists the 'redistributive
state', which controls the admissible range of contractual
arrangement and defines admissible property tenure. If taken
too far the redistributive state can create disincentives which
are wealth impeding

26. • Not all individuals have equal access to the political process.
Political systems, like markets, have varying degrees of
imperfection.
• The conflicting values in society are resolved via the courts
etc., but these outcomes are negotiated and temporary, and
reflect the self-interest of the parties to the negotiated
settlement and their view of what constitutes a 'fair' solution.
• Individuals will subject themselves to collective restraints
on their individual action if they believe it will foster collective
fairness and this does not deny the importance of self-
interest(Commons).

27. The Modern-Day Apostles of Laissez-Faire
• There are logical grounds for government regulation and
control of market activities.
• Government attempts to adjust the overall allocation and
distribution of resources in the economy because various
imperfections cause the market system to fail.
• However, government intervention does not bring about a
perfect allocation of resources, either. The policy
instruments used by government introduce other
inefficiencies and distortions into the economy.

28. Theory of the Second Best
• The theory of the second-best demonstrates that
government intervention might make the situation worse off
rather than better off.
• In designing optimal government policies it becomes
necessary to weigh up the Allocative and distributional
inefficiencies of the market with the Allocative and
distributional inefficiencies created by government
intervention.

29. • To assume that government can improve upon all market
inefficiencies is a naive position to adopt.
• Some economists, along with some social philosophers, are
concerned about dimensions of the effects of government
other than the Allocative inefficiencies that it might
introduce.
• Friedman focuses attention upon the effect of government
on personal freedom and liberty.
• It is instructive to weigh up the functions of government
which clearly limit the sphere of government activity:

30. • The state exists to protect the rights of individuals;
nevertheless there exists a tension. The state can become so
strong in protecting property rights that it becomes coercive
and a threat to individual freedom.
• Individuals voluntarily give up sovereignty to governments
on the assumption that the government uses it correctly.
• Modern states need to have built into them checks and
balances- an amount of decentralized power and
systems of accountability.

31. Marxian Political Economy
• Liberal economists do not stand alone in their criticism
of the modern state. Marxists, whilst adopting a different stance, are
equally critical. There are three broad functions of the state:
• 1- Accumulation:
The state tries to set favorable conditions for the
accumulation of capital.
• 2- Legitimation repression:
The state attempts to maintain social order and social
control whilst at the same time preserving social harmony
and avoiding social conflict. Education (which is state
produced) serves the purposes of social control and also
legitimating. The state, however, by favoring the interests
of one class (capital) over another, can itself be a source of
conflict.

32. • 3- Social reproduction:
Socialization is broadly defined as the way in which
`social beings' are reproduced. Part of this is undertaken
by the family but part is carried out by the state in a system
of state capitalism (or the mixed economy).
• The welfare state supplements and modifies the
traditional role of the family and has been responsible for
changes in the structure of family life, in particular the
disappearance of the extended family (e.g. family
allowances, supplementary benefits, 'free' health, child
welfare, etc.)

33. Paradox For Marxists
• The welfare state is the child of the labor movement yet is
used as a means of social control to serve the interests of
capital.
• There are two forces at work. First, there is pressure from
below, from interest groups who demand policies that will
serve their interests.
• Second, there are pressures from above; the state
implements social policies that will serve the political
interests of capital.

34. • Gough (1983), argues that these two movements have
reinforced and strengthened each other in the UK over the
postwar period.
• Keynes and Beveridge represented a linked response to the
postwar crisis in Britain, focusing on demand management
and the sphere of social reproduction.
• Together they formed the core of the "postwar settlement"
between capital and labor which was to prove so successful
as a basis for postwar prosperity

35. Contradiction In The Keynesian-Beveridge Welfare State
The contradiction in the Keynesian/Beveridge welfare state are as
follows:
• (1) Public/social spending cannot expand as a share of GNP
for ever. As public spending increases there is, therefore,
conflict between capital, labor and the state over the
distribution of GNP.
• (2) Higher taxes (to pay for higher social spending) can result
in a demand for higher net money wages; which will set up a
wage/price spiral. This will worsen international
competitiveness, reduce profits and increase unemployment.

36. • (3) The disincentive effects of public spending and
taxation will interfere with the generation of surplus and
profit.
• These arguments, which depend upon a more careful
specification of the under-lying microeconomic processes,
would not necessarily be disputed by economists of other
ideological persuasions.

37. Conclusion
• There is no doubt that 'political failure' is just as real a
phenomenon as is 'market failure'. Public sector
bureaucracies do not operate frictionless and without cost.
Inefficiency, malfunction and bureaucratic inertia do exist.
• The public sector is frequently asked to perform tasks which
in complex, uncertain and rapidly changing environments are
impossible to achieve.
• What is necessary is to discover the limits of government
action and to define more clearly the comparative advantage
of the public sector in a mixed economy

38. “Ashraf Khan” is discussant of this
topic. He will further discuss this
topic in class.

39. The End