North’s definition of institutions implies that the institutions could be formal (for example a legal code, a constitutions, or a regulatory body) and they could also have less formal constraints (for example social norms, or traditions, that help to determine outcomes). It will be difficult to mention institutions without mentioning government and the role it has to play in establishing the rules of the game. Government intervention in the economy is justified by the existence of market failures – the case where the unfettered operation of the market fails to produce the best possible outcome.
Market failures include externalities like pollution and the inability of private firms to provide public goods, such as roads. Another form of market failure that can motivate government economic policy is the existence of monopolies, single firms that are the sole suppliers of a particular commodity. And industry such as electricity transmission is often viewed as a natural monopoly because it would be impractical for several companies to string electric wire to every house.
In this case, there is a role of government regulation to prevent the monopolist from charging an inefficiently high price. The market failure can also occur in cases requiring the coordination of activities by many firms or many people. Some potential coordination failures and the need for the government to correct them are obvious. It useful for everyone to drive on the same side of the road, and even the most diehard free marketer would have little objection to letting the government announce which side it should be.
However, a market failure is not the only reason that governments become involved in the economy. Another motivation for the government to get involved in economic matters is the income redistribution – the transfer of income from rich to poor, from working-age adults to the elderly, or from the general population to members of some favored groups – as one of their proper roles. On the other hand, only few economists argue that there should be no government intervention in the economy.
It is rather a question of in which degree the government should intervene. The case against government intervention starts with the observation that, although proper government policy can theoretically fix any market failure, in practice it often fails to achieve its goals. When government tries to take the place of private firms, the resulting enterprises tend to operate inefficiently because they lack the incentives, specifically profit, that motivate private firms.
In cases where industries are regulated as natural monopolies, often such regulation effectively preserves the absence of competition In the case of public goods, the debate centers on the question of whether some of the goods that governments supply could have been supplied privately if government had not taken over their provision. In different countries, privatized activities have included the building of roads and telephone networks and the operation of jails.
A parallel trend has been the deregulation of industries – removing them from government supervision. The issue of income redistribution presents some of the most difficult questions regarding the proper role of government. In this case, the benefits of such a policy (a greater degree of equality) are of a different nature than the costs of the policy (a lower degree of efficiency). However, critics of big government point out that much of the income that governments redistribute does not flow from rich to poor.
Rather, it is redistributed among people in the same income groups, who are at different stages of their life cycles, as when taxes are taken from working-age adults and transfers are paid to elderly. Critics argue that these redistributions have a large effect on the efficiency with which the economy operates but do little or nothing to improve equity. In general, the success of any government intervention depends crucially on the ability and the honesty of the officials entrusted to carry it out.
When these qualities are lacking, the resulting government failure can be worse than any market failure that government policy was designed to correct. By looking at different cases of government intervention and the cases against government intervention, I will focus on explaining the tools that governments use to influence the economy. These tools include: the provision of the rule of law, regulation of how firms behave, planning (direction of resources to certain targeted industries), trade policies such as tariffs and quotas, and outright ownership of the means of production.
One of the most important public goods that governments provide is the rule of law. In an environment where the rule of law is weak, the factors of production would not be accumulated and the economic activity would be plagued by inefficiency. For both these reasons, the output would decline. In the absence of a legal infrastructure, many of the investments made in a modern economy would not take place because investors would be unable to earn a reasonable return on their money.
The rule of law cannot be taken for granted in most of the world. In many countries the judicial systems are weak, and legal cases are as likely to be settled on the basis of who has better political connections as on legitimate legal claims. According to Douglass North, who won the Nobel Prize in economics in 1993, “The inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World”.
One of the best examples that illustrates the importance of the rule of law is the former Soviet Union case. With the breakup of the communism, the legal structure surrounding basic economic activity became highly uncertain. The line between legitimate business and organized crime blurred, as assets formerly owned by the government in trust for the citizenry as a whole rapidly found their way into the hands of a well-connected few.
In this legally unstable environment, income per capita in the Russian Federation fell by 12% in the decade following the 1991 breakup of the Soviet Union. Another important way in which the government affects the state of the economy is by its sheer size. Government that spends a lot of money requires big government revenue and vice versa. Governments raise funds by taxing the citizens and businesses. A few countries, such as Saudi Arabia, make the exception where the natural resource is the primary source of revenue.
According to the social scientist Adolph Wagner “the size of the government would inevitably increase as countries became wealthier, because a more developed economy requires more complex regulation and because many public goods provided by the government are of the type where desired spending rises more than proportionally with income”. Taxes are relevant for economic growth because they directly affect the efficiency with which output is produced. The larger the tax is imposed in a given market the smaller will be the number of transactions that will take place.
This means that raising the tax rate will lower the tax base. When taxes are high, some of the potential transactions between buyers and sellers will not take place, and these transactions would have made both groups better off. No tax will be collected on these forgone transactions, but by discouraging transactions, the tax made the potential buyers and sellers worse off. The size of this inefficiency grows with the size of the tax. Because higher taxes shrink the tax base, increases in revenue collected when tax rates rise are not proportional to increases in tax rates.
The fact that taxes cause inefficiency in the economy does not mean that there should be no taxes. Government provides public goods without which the economy could not function at all. These public goods are paid for taxation. Thus, even if the government were solely concerned with maximizing GDP per capita, the optimal choice of public goods and taxation involves a trade-off between the costs and benefits. However, not all of the money that governments collect as tax revenues goes toward supplying public goods.
One of the major functions of government is to make transfers of income to people. The largest transfers are old-age pensions; other transfers include unemployment benefits and welfare payments to the poor. Government planning and the protection of infant industries with tariffs have failed, in almost most of the cases. The economic planning occurred in the decades after WWII, when governments in newly independent countries in the developing world experimented with various policies to improve their backward conditions. State enterprises, for example, were totally inefficient.
The managers of these enterprises, facing neither competition from other firms nor pressure from shareholders to produce profits, had little incentive to strive for efficiency in production. Marketing boards, which were initially supposed to raise farmers’ income, ended up doing just the opposite as government officials could not resist the temptation of the revenues that passed through their hands. Trade restrictions were also counterproductive. In theory, infant industry protection should have been offered only to industries where a country had a chance of being a competitive producer.
In practice, governments protected any industry which enough political power – and often all industries indiscriminately. Furthermore, most of the “infant” industries that were protected never managed to grow up. Facing no pressure from foreign competition, they remained inefficient. As one can notice, institutions determine incentives and constraints and shape outcomes. Different groups and individuals will benefit from different institutions. Therefore, the institutional choices will depend on who has the political power.