UNIT 1 WELFARE FOUNDATIONS OF

ECONOMIC POLICIES
Structure
1.0 Objectives
1.1 Introduction
1.2 Public Economics
1.3 Public Choice and Social Choice
1.3.1 Two Basic Systems
1.3.2 Forms of Democracy
1.3.3 Voting
1.3.4 Majority Rule
1.3.5 Individual Preferences
1.3.6 Multiple Voting
1.3.7 Plural Voting
1.3.8 Rank Voting
1.3.9 Point Voting
1.3.10 Strategy
1.3.11 Political Parties
1.3.12 Bureaucracy
1.3.13 Positive Theory

1.4 Economic Role of Government

1.5 Role of Government in a Mixed Economy: Changing Perspective
1.6 Let Us Sum Up
1.7 Key Words
1.8 Some Useful Books
1.9 Answer or Hints to Check Your Progress
1.10 Exercises
Appendix 1.1 Public Intervention
Appendix 1.2 Mixed Economy

1.0 OBJECTIVES
After going through this unit you should be able to:
• Sketch out the domain of Public Economics;
• Appreciate the welfare foundations of economic policies;
• Understand the idea of public choice and its basic approaches;
• Delineate the role of government;
• Capture the characteristic features of public interventions; and
• Appreciate the changing perspective of governance in a mixed economy. 1
Public Economics : The
Basic Concepts 1.1 INTRODUCTION
The term Public Economics came into existence only in 1960s though a few titles
with nomenclature like Public Finance had already started covering much ground,
which is today covered within the realm of Public Economics.
Public Economics is often called as applied welfare economics. It underlines the fact
that some notion of social welfare or economic welfare of the society lies underneath
this branch of economics. Even though a social welfare function may not always be
explicitly specified, the notions of efficiency and ethics/equity and the
complementarities and tradeoffs between the two generally remain at the back of
mind while formulating and evaluating public policies dealing with economic aspects.
More deeply, it concerns the kind of relationship that exists between individual
preferences for own-selves or social states (social alternatives) and societal preference
under different criteria of choice. For example, which criterion one would apply
while undertaking a project, which may displace some people from their homesteads
and livelihoods: (i) post-project sum total of individual utilities is higher or not; (ii)
nobody is displaced if displacement means loss of utility to those who are displaced,
whatever the gains for others, or (iii) the people displaced are adequately compensated
for their perceived loss. Likewise, whenever there is a discussion of reservation of
jobs in employment, seats in educational courses or items for production in small
scale sector there is involved one or the other criterion of ethics which gets juxtaposed
with efficiency.
In last fifty years there has been a further development that economic approach
came to be applied in the arena of public decision-making process, which broadly
covers many political and bureaucratic processes and the interface between the
two. This has come to be included in the name of public choice in the area of Public
Economics. Outcomes may a great deal depend on the process adopted and therefore
the underlying behavioural assumptions of actors and implications of the processes
in practice came to be studied.
Why should and how should the State intervene through the government apparatus
in the economic sphere of the country, has been an important discourse in economics
for long. According to one theory, the institutions of State and private property
(following which, market) came into being simultaneously. Even if this theory is not
accepted it appears very plausible that the State undertook to protect private property
(along with life of its citizens) and charged fees for service in terms of a proportion of
produce, which was largely agricultural corn so that it could support its protective
force. But later on, as the economy of a society developed in terms of commodification
of goods, its State assumed the charge to regulate some of its economic activities or
some aspects of many activities, like standardization of weights and measures and
coinage. Still later, the State intervened in commodity market by taxing and/or
subsidizing different commodities with a view to impacting on (reducing or augmenting)
their demands and supplies if they were not, in its perception, in congruence with
societal interest. Later, one finds that many community-oriented welfare activities
were also assumed by the State directly or through its subsidiaries.
For a very large part of the twentieth century, we may recall, there existed capitalist
market-oriented economies and socialist planning-oriented economies. Twenty first
century is however witnessing that all modern economies are of a more mixed sort.
But there exists full spectrum of mixed economies in the world. For example, one
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may find that the government expenditure as a proportion of the gross domestic
product may vary from 20 per cent to 70 per cent in different countries and yet the Welfare Foundations of
Economic Policies
division between the national and regional/local governments may differ greatly. One
size and one shape will hardly fit all, one may tend to argue, as different countries are
at different stages of development. As all fully developed men are not of same stature
and not of same complexion, different countries will continue to differ from each
other at any point of time. Yet there is some tendency of convergence in economies,
which is true about role of the government intervention in the economy.
We propose to broadly hint at the scope of Public Economics, the rationale of
public intervention in market, and the methods of decision-making for intervention
by the State in the economy. We also propose to discuss and delineate the role of
government in an organized society and the changing perspective in a mixed economy.
We shall also cover the relationship between public sector and private sector in a
mixed economy.
However, we will like to remind that the treatment in this unit shall be more at an
introductory level. They will be more adequately treated in subsequent units.
However, there are two enriching appendices to the unit, which you may like to go
through.
Check Your Progress 1
1) Why Public Economics is often called applied welfare economics ?
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2) What could be a quantitative measure of public intervention in an economy?
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3) Try to sequence public intervention in economic sphere in terms of stages?
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4) Why would public intervention differ from economy to economy?
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Public Economics : The
Basic Concepts 1.2 PUBLIC ECONOMICS
Public Economics can broadly be understood as that Economics which deals with
public intervention in the economy. Its domain is supposed to encompass rationale
for public intervention as well as the manner, approaches, forms, mechanisms,
processes and instruments whereof. The term ‘public’ has a restricted meaning: it
generally connotes government, as such, at all levels as well as public bodies, that is,
the bodies floated by the government at any level. The term ‘public’ may also refer,
in certain cases like public choice, to the people in general, which are supposed to
participate in a democratic process of electing political representatives as well as
options related to social/political/economic spheres. It does not however connote
any collectivity of people, which is not mandated by the government, irrespective of
its size.
The State attempts to oversee, as exemplified by Art. 39 (b) and (c) of our Constitution,
that private activities may not cause harm to the common good and in case they do
so corrective actions are taken by the State. The government does therefore intervene
in a variety of matters, economic and non-economic. But concern of Public Economics
is largely intervention into economic sphere much beyond fiscal politics as the sphere
of economics is enlarging by day because, for instance, many environmental problems
are being discovered to have economic implications. Yet Public Economics may
also concern with the problems and pitfalls of public intervention as such or its
particular forms.
Government should intervene in the economy is today a foregone conclusion but the
manner in which and the extent to which it should continues to be an issue. It is
needless to say that exact complexion of intervention will a great deal depend on the
complexion of the economy as well as on people’s choice (and perhaps the manner
in which people choose to make the choice or are made to make the choice). Yet, it
is broadly agreed that the government intervenes in the economy for influencing the
allocation of resources between activities, keeping in view the present and the future,
the distribution of resources between individuals and their collectivities, keeping in
view again the present generation and the future generations. This is in the long run
interest of the society. However, intervention may be needed for stabilizing certain
parameters like growth, unemployment, prices, foreign exchange, etc. so that the
economy does not get drifted away from its desired course. This became duly
recognized in literature after Keynes though various States did come to rescue
whenever people were in distress.
Should the intervention be direct by undertaking— owning, controlling and
managing— a particular activity or somewhat direct through regulating it or indirect
through tax-subsidy mechanism or even how much direct? The answer varies from
society to society and changes in any society with changes in internal and external
environment and mutation in technological innovations and institutional complexion.
Overtly, the purpose is to serve public interest!
Public Finance was always dealing with intervention through fiscal instruments,
including federal relationships between different tiers of governments and later on it
subsumed Public Finances dealing with public sector enterprises when many private
enterprises were nationalized and/or new enterprises were established in the public
sector. Although public works were very much in the public sector domain even if
many of them were erected through outsourcing to contractors. Public Finance
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generally did not cover the regulatory aspects of intervention, except in the context
of public utilities or natural monopolies. This becomes part of Public Economics. Welfare Foundations of
Economic Policies
The process of democratic decision-making and problems associated therewith is
now discussed under the rubric of public choice, which has been included by most
economists in the scope of Public Economics.
Certain textbooks are more concerned with appraisal and evaluation techniques of
large projects while others dwell on the theory of second best as in real economies
conditions of perfect competition hardly exist and distortions in one part of the
economy may have to be balanced by causing distortions elsewhere if the former
cannot be done away with.
In short, study of Public Finance (including Public Revenue, Public Expenditure and
Public Debt), Public Enterprises/Firms, Public Projects, Public Utilities, Public
Services and Public Choice would broadly form the realm of Public Economics.
They may be concerned with any level of government— national, sub-national or
local.
Over last fifty years there has been a curious development in the matter of local
governance. It has been argued that people may vote with feet instead of by show of
hands. It means that individuals may quietly mere across local jurisdictions for the
preferred package of local public goods like sanitation, road conditions, aesthetic
view. The conditions of such occurrence/phenomena as this have been a matter of
research.
However, we may note, public intervention through money supply, interest rate,
foreign exchange rate, etc. by monetary authorities is still not covered by most
textbooks in its domain though it logically belongs to Public Economics. Part of the
reason for non-inclusion of this kind of public intervention is the fact that most of
Public Economics grew out of microeconomic theory as applied to public intervention
in the market while most of monetary and exchange rate intervention comes from
macroeconomic domain. In this unit we shall occasionally refer to these interventions
as well. Yet, there are books (such as one by Leif Johansen), which deal with
macroeconomic interventions. In fact, the area is still not well settled.
Check Your Progress 2
1) Attempt to define Public Economics?
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2) Delineate the scope of Public Economics?
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Public Economics : The 3) Explain how public intervention tries to influence allocation and distribution of
Basic Concepts
societal resources.
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4) What do you mean by stabilization of the economy?
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5) Which kind of public intervention is not still considered a part of Public
Economics and why?
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1.3 PUBLIC CHOICE AND SOCIAL CHOICE

Why does government undertake an economic activity? If an activity has large
externality or spillover and involves a large number of people, it may be found better
that government undertakes it. As David Hume once pointed out, it is easy for two
persons to agree/bargain for terms of draining a field affecting them but it would be
very difficult for a large number of persons to make the decision on terms of sharing
cost of drainage.
Who permits the government whatever it does? The simple answer could be: people
in a democracy and the monarch/dictator in a monarchy/dictatorship. But neither
monarchy exists in its original form nor a dictator/despot/autocrat works without a
coterie around. Some people always participate in the decision-making process,
deliberate on the issues and implications, and clinch the matter following certain
rules given from outside (say, by the constitution) or decided in the process itself,
which is itself a decision-making process. How individual preferences get translated
into public choice over a public issue is broadly the area of Public Choice.
Who will participate and how the decision will be made are the issues concerned
with the Public Choice. Whether the participants are guided by social concerns or
they harbour their private interests as well and what the implications of different
behaviours are. Whether the participants are citizens or their elected representatives
and how they were elected, or they are part of selected personnel of bureaucracy.
Whether it is voting by secret ballot for election of representatives or a committee is
meeting using no-dissent rule or a board is meeting where the chair finally rules.
6 These are the questions Public Choice deals with.
Social Choice is a very kindred area. Some people do not make any distinction Welfare Foundations of
Economic Policies
between the two while others make. Social Choice theory verily concerns with the
relationship between individual preferences and social choice. There is attempted
some kind of aggregation of individual preferences but individual preferences refer
to individuals’ preferences from a social standpoint and that is why many analysts
including Arrow suggested the phrase individual values which means social values or
value judgements or social views of the individuals.
If we were to distinguish between the two, we would prefer to call a Social Choice
that collective choice which involves all individuals to participate in the decision-
making that affects them all, and a Public Choice that collective choice which involves
those individuals who represent the interests of all individuals, to participate in the
decision-making that affects all those who are represented by the participants. It
means decision-making through legislatures, parliaments, cabinets, committees,
commissions, tribunals, boards, etc. would be all the cases of public choices while
referendum and popular elections would be the cases of social choices. Some have
preferred to call such exercises as problems of public choices and others have
preferred to do vice versa. Still others have used the term Collective Choice for
both types of exercises. Dennis Mueller suggested that Public Choice is a collective
choice more on positive lines and social choice is collective choice more on normative
lines. In fact, the term Public Choice came to be coined much later and works on
Public Choice were using term Social Choice for the kind of decision-making
processes today called Public Choice.
Public Choice Theory of Government Intervention is a growing area. It is said, in
short description, to be an application of economics to study of politics. Actually, it
is the use of economics methodology in analysis of political institutions, mechanisms,
phenomena and processes, encompassing government, bureaucracy and judiciary.
The methodology chiefly employed is one of the methodological individualism, which
means it accepts contractarian, rather than organic, conception of State. The individual
treated in this area of study is egoist, rational and utility-maximiser. Homo politicus is
patterned on homo economicus. It chiefly deals with voting behaviour, voting systems
and voting rules, possibility of logrolling and behaviour-modifying strategy, influence
of pressure groups and party-politics, optimal majority questions in terms of associated
costs, etc. Use of game theoretic framework, transaction cost framework and
probability of whether an individual’s vote is crucial in decision-making have engaged
minds of many a worker in this sub discipline.
Wherefrom come the rules and why there is not one single rule for all kind of decision-
making from amending the Constitution to building a rural road connecting a village
with a highway. What are the activities, which may have to be collectivized? These
are the problems Public Choice deals with. Constitution-making by free citizens in
terms of form, content and process as well as causes and conditions of revolution
are very much questions some scholars have addressed to.
In order to provide some flavour as to how the decision-making process operates in
various settings, we provide below details regarding voting rules, procedures, systems
and strategies.

1.3.1 Two Basic Systems

As against monarchy/dictatorship/despotism/autocracy where one designated person
is supposed to make decision, chosen few under aristocracy or asserting few under
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oligarchy are allowed to make choice. By contrast, in a democracy all citizens—
Public Economics : The subject to simple qualifications like age are allowed to vote in the decision-making
Basic Concepts
process, which includes election of people’s representatives. For long, we might
have had qualified democracy where only those who were educated to a certain
level or those who had property beyond a threshold could participate in the political
process. For long, in Europe, women were proscribed to vote. It was great news in
early 1970s when Switzerland permitted its womenfolk to vote. In a democratic
polity, ‘one person, one vote’ is the principle, which is hallowed as political
egalitarianism. Of late, we are witnessing democratic delegation of decision-making
power to a single person called supremo or the high command consisting of a few at
the top. This phenomenon has not still been studied in formal academic literature.
Further, there could be a very similar process of decision-making in joint stock
companies, which should not detain us here.

1.3.2 Forms of Democracy

Direct democracy and representative democracy are two forms of democratic
decision-making. Let us use Indian context to buttress our arguments. Resolutions
made in the meetings of a gram sabha may well be likened with direct democracy.
Elections to state legislative assemblies and lower house of the parliament (lok sabha)
are examples of direct democracy while those to state legislative councils and upper
house of the parliament (rajya sabha) are examples of representative democracy.
Prime minister is chosen by members of Parliamentary Board of the party asked to
form the government whereas the Prime Minister alone chooses the cabinet. Then
there are several cabinet committees for specific purposes and consultative groups
with each ministry. There can be a similar structure at local level as well. There can
thus be rules facilitating choice by one and there can be rules facilitating choice by all
as well as there can be rules facilitating choice by a majority/minority. For an electorate
of 1000 (and 1001), simple majority is 501. It is understood that the people whom
the decision would impact generally accept these rules. We will leave the question
as to how the rules came to be accepted and to what extent they are accepted.
Surely, there exists a possibility of some dissatisfaction on the part of some members
if the decision is made by a rule other than unanimity or consensus.

1.3.3 Voting
Voting does not concern only election of representatives but also options on war, on
prohibition, on budget, on a particular item of budget, on pricing services of a utility;
and options may be more than two. Let us consider for the present the one-person-
one-vote system. If there are two options, rules could be unanimity, consensus,
simple majority and qualified majority. If unanimity is the rule, then a single dissent is
as good as the veto; everyone has veto power here. Consensus is usually a sort of
unanimity arrived at after some deliberation. Logrolling through vote trading across
issues among voters is often seen in the legislatures in the West; it may improve
majority voting but is often detested on moral grounds.

1.3.4 Majority Rule

Simple majority means at the minimum an integer number just crossing the mark of
50 per cent. Qualified majority means 2/3rds or 4/5ths of the votes, as prescribed
under the law, and is also known as absolute majority. Many constitutional
amendments require a qualified majority. However, if there are more than two options,
the option that gets the highest number of votes wins or gets chosen. In extreme
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case, winning number can be as low as an integer just crossing (V/n) where V is the
number of votes and n is the number of options. If V is 100 and n is 10, then the Welfare Foundations of
Economic Policies
winning number can be as low as 11 where someone gets 9 while eight others get 10
each. But it is possible that the winning option secures more than 50 per cent. If V is
100 and n is 3, the winning number must be no less than 34.
Using minimum cost principle, taking account of external cost and decision-making
cost, one can find that an optimal majority rule may differ from issue to issue and
may not be a case of simple majority, defined loosely as 50 per cent plus one votes
or 51 per cent votes.

1.3.5 Individual Preferences

Whether individual preferences are single peaked or multi-peaked, is an important
question. If I prefer low to moderate and moderate to high, my preferences are said
to be single-peaked. If I prefer high to moderate and moderate to low, again my
preferences are said to be single-peaked. If I prefer moderate to high and moderate
to low, which amounts to saying I prefer central/neutral posture to both extreme
postures of left (or progressive) and right (or conservative), my preferences are
again single-peaked. But if I prefer both low and high to moderate, or equivalently
extremes to middling options, then my preferences are not single-peaked. They are
multi-peaked. All-or-nil behaviour is a problem.
It has been proved that if all voters’ preferences are single-peaked then the median
voter wins. The voter who divides the distribution of options ordered in the sequence
of least to highest through moderate in two equal halves. It can be suggested that
political parties often tend to woo the median voter. One may further find that the
political parties with extreme positions to begin with have been moving over time
towards central positions in many democracies. Indian democracy is a case in point.
We notice that the parties starting with extreme postures on political ideologies or
caste combinations are converging to similar positions.
It is important to note that if all individual preferences are not single-peaked, majority
rule may not give a unique outcome: The outcome may depend on the sequence in
which the issues are paired. There may exist cyclicity. This outcome is known as
voting paradox. When Kenneth Arrow put this result forward, it came as a shock to
one’s faith in electoral democracy. Many, including Musgrave, have pointed out that
for majority rule to work—that is to give a non-arbitrary result—the preference
structure of individuals must be typically single-peaked. However, the result of median
voter wins works only when different options can be ordered in some quantitative
way (at least in lexicographic ordering). However, if options are like colours, we
cannot sequence the values. Different compositions of budgets with same total may
again not be ordered in a sequence. Then the meaning of median voter wins becomes
obscure.

1.3.6 Multiple Voting

If an electorate of size P has to elect a number of representatives (n) from among the
candidates (N), where n<N<P, then a better choice is exercised as a voter may
vote, depending upon his intensity of choice, for one candidate, two candidates or n
candidates. The same could be said about when a number of issues have to be
elected for discussion or items have to be given first priority.

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Public Economics : The 1.3.7 Plural Voting
Basic Concepts

Suppose there are 20 candidates and 100 voters, the candidate getting 6 votes can
also win by this rule. In some countries, this is not considered a majority rule. Each
voter is allowed to rank the candidates in order of preference. If nobody secures at
least number of 50 per cent votes just exceeding from the first choice, then the
second choice is counted. In case nobody again secures 50 per cent +1 votes, then
the third choice is counted. The process is stopped when someone secures at least
that number of votes which just exceeds 50 per cent of the total. Thus, simple
majority defined by 50 per cent marks is adhered. Note that the party with highest
number of members of parliament is not allowed to form the government if this
number is less than 50 per cent. A candidate who has support of no less than 50 per
cent members is supposed to be invited to form the government.

1.3.8 Rank Voting

Ranks could be used in another manner. Ranks are treated as cardinal numbers and
are added up. The option scoring the minimum would win if the best choice is ranked
first and given the score 1. This is often known as Rank Voting or sometimes as
Plurality Voting method of decision-making. That, under certain circumstances, no
unique outcome may come out, has been an issue of debate. Then the order in
which binary options are presented becomes, may be crucial.

1.3.9 Point Voting

I prefer option A to option B but how strong is my preference for A over B is not
adequately reflected if I am just allowed to rank the options. The suggestion is that
I may be allowed to exercise 100 points, which I may allocate in accordance with
strength of my preference for different options. If there are ten options, I may choose
to allot all 100 to a particular option and nil to all others, which is what I actually do
when I am allowed to cast single vote even when I do not so strongly reject others.
But I may also choose to allot 10 points each to all options, which means I am totally
indifferent between the options. The outcomes in all systems would be the same for
majority rule if options were only two. In a multi-option situation, the outcomes are
likely to differ under ‘ayes’, ‘ranks’ and ‘points’ systems.

1.3.10 Strategy
Real world is not so simple. We are witness to and participants in the politics of
voting. If I know or guess that my most preferred option in any case is not going to
win, I may vote for my second preferred option lest still less preferred option (or
negatively preferred option) wins in the election. In that case, voters may distort
their real preference when it comes to revealing them. Since many voters may choose
to do so, the outcome will depend on political skills of voters, and candidates, and
supporters. Therefore, in many cases, rules are less crude than simple majority system.
Some options or candidates may not be real. They may be put as dummies as a
strategy. Then, public choice becomes a more complicated exercise. A bureaucrat
may do the same by posing irrelevant options in the menu.

1.3.11 Political Parties

There could be a situation where only options are actually contesting and people are
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participating. There could be and is in reality a situation where not only options are
contesting but political parties, holding different ideologies, are also contesting. Political Welfare Foundations of
Economic Policies
parties are often found to impose certain discipline and therefore the representatives
may not reflect the preferences of their electorate but the stand of their party. There
are various qualifications for political parties under People’s Representation Act and
Rules, whereby simple democratic principles are compromised. Campaigning for
support is costly, obtaining information about people’s preferences is costly, collecting
information about the true costs of alternative options may be costly or knowing the
incidence of the cost among individuals. These are also the points to be considered
in Public Choice Theory.
Then, there could be charismatic leaders to influence the thinking of the people and
make them vote for fascism!

1.3.12 Bureaucracy
Who set the agenda in the parliament, who create the options on an issue, and who
frame many rules, which govern even the filing of nominations? Who propose the
demands for various departments in the budget and who put up the file for projects/
programmes? Bureaucrats do all this, may be with the advice of the political executives.
Much in the same way as managers may have their own interests pitted against the
shareholders’, bureaucrats have their own axe to grind in the whole political drama.
They may, for example, favour large projects, which increase their prestige and may
prefer those, which have large expenditure in the present rather than in future if they
think their stay in office is going to be short. It does not mean that they do not serve
any public purpose. Further, there may be competition among bureaucrats as there
could be collaboration.

1.3.13 Positive Theory

As against what the government ought to do, Public Choice Theory, it can be
concluded, deals more with what governments do. Sometimes governments, now
feel economists and political scientists, can make bad decisions or execute good
ideas badly. This branch of economics (and of political science) examines the way
government decisions are made and in particular voting mechanisms function. It
examines the factors for government failure and behaviour of constituents of
government. So far it has been concluded that there exists no single ideal way to
translate individual preferences of social states into unique social choice. Yet, certain
outcomes are better by certain standards but what these standards are and whether
they are acceptable to people and by what criteria.
Check Your Progress 3
1) Delineate the area of Public Choice Theory.
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2) Discuss the relationship between Public Choice and Social Choice.
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Public Economics : The ...................................................................................................................
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3) List various rules of decision-making.
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4) Explain the methods of plurality voting and point voting.
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5) What is median voter theorem? When does it not work?
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6) What is logrolling? What is strategic voting? Differentiate between the two.
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7) Why are bureaucrats interested in projects that have large expenditure in the
present?
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1.4 ECONOMIC ROLE OF GOVERNMENT

We have discussed the role of government in sections on Introduction and Public
Economics with a variety of spheres. It would be good to go through Appendix 1. It
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should be easy to see that these roles could be categorized in various ways as
microeconomic/macroeconomic, direct/ indirect, or participatory/regulatory or as
measures of allocation/distribution/ stabilization. While a sectoral policy is Welfare Foundations of
Economic Policies
microeconomic in nature as it affects production units—firms and farms, factories
and workshops, grocers and service providers, attempts to raising fiscal activity or
bringing it down or intervening in forex market to regulate flow of investment may be
macroeconomic. Actual budgets and plans contain both the elements.
Making laws to ban/prohibit certain activities or rationing supply of imports through
government establishment is direct while influencing supply and demand through
tax-subsidy mechanism or promoting development of capital market through
provisions in tax laws in the budget is indirect.
Undertaking to produce steel, run railways and generate electricity power in nuclear
plants may be participatory while reserving items for small scale units, watching over
or monitoring private telecom operators or directing capital market is regulatory.
One should be able to see that they influence either or both allocation and distribution
of resources—primary, intermediate and final, and many are resorted to save the
economy from general instability or sectoral fluctuations. The US government may
be subsidizing agriculture sector for export and so may be doing the Indian government
for sustaining production whether subsidizing inputs or buying agricultural produce
at support prices.
Private parties may build roads though they did not build roads in India till the other
day. Canals in the seventeenth-eighteenth centuries and railroads in the nineteenth
were built by private parties in the Great Britain. Railroads in India were also built in
the beginning by private (English) parties with some assurance from the government.
But private parties may not build dams whether it is India, Britain or the US. Then
the government has to come forward. There may be many such areas where the
State has to step in. In certain cases, the reason may be requirement of huge capital
and in others, huge risk, which may be beyond the capacity of private capital.
We have discussed in some detail elsewhere about public intervention in terms of
public enterprises and public intervention in affairs of private enterprises in terms of
license for establishment and permit for capacity enhancement. But private sector
could go for an enterprise with state participation in equity or seek financial assistance
in terms of both equity and capital. A good number of companies were floated by
the central government in India after announcement of the Industrial Policy Resolution
of1956 with major equity share and rest of equity coming from some state government
(depending upon location), foreign investors and Indian public. Following the
conversion of loan from the public financial institutions into equity capital, many
private enterprises were converted into joint ventures. In many states, mixed ventures
of State Road Transport Corporations were created.
It is noted by many of us that major banks and insurance companies were nationalized
between 1955 and 1980 but that a lot of financial institutions in public sector were
floated from time to time to help mobilize resources for private enterprises, is not
given equal importance. When it was felt that private banks were not able to spread
banking through the length and breadth of the country, to inculcate banking habits in
the masses, to mobilize savings of small savers, and to finance small industries and
trade, large private banks were nationalized in 1975 and 1980.
When private industries fall sick and labour has to be laid off, most governments
have been finding it to be their duty to take them over in the hope that the government
will be better able to run them and protect interest of both consumers and workers.
In India, as also elsewhere including the Great Britain, many industries were taken 13
Public Economics : The over when they fell sick. There were created statutory corporations to run these
Basic Concepts
commercial enterprises.
In certain cases, existence of monopoly is natural and in overall interest of the society
but private pricing principles fail to produce efficient level of output or to provide fair
return to the owners. Regulation of prices in such cases in inevitable. Many a time
the State establishes such utilities and at others it simply regulates them. Regulation
of market may sometimes be necessary, thanks to asymmetry of information, to
protect consumers from spurious material or short weight or hike in price or artificial
scarcity.
Public intervention to correct distortion due to presence of externalities and to
provision of public goods has been discussed in Appendix 1 and elsewhere. These
measures may be called remedial when private actions are modified to yield socially
optimum results.
Making market function better by correcting for distortions and supplement where it
cannot help market function well could, in short be the role of the government.
Besides the factors of market failure, which we have preferred to discuss in
Appendix 1 and Unit 2, there are other reasons for the government to play a role. If
markets fail to deliver socially desirable outcomes in optimal combination, then the
State enters the arena. Social justice and reduction in poverty has been a concern of
most governments for quite some time now. There may be a case for positive
discrimination in favour of certain social groups or economic occupations as well as
policies and programmes for attenuating magnitude of poverty, if not inequality. They
may well cover employment programmes—self- and wage-, public distribution
through fair price shop network or social security and other welfare measures.
Working conditions of the workers improved in the West because of rise in
productivity but that could not happen on its own but because of assertion of labour
through trade under movement. Later, the government entered to ensure better
working conditions in terms of number of working hours, facilities in workplace and
payment of wages pension, etc. These are often known as labour welfare measures.
However these measures are often meant for organized sector.
Merit goods are another area. Merit goods are private goods better consumption of
which is in the long run interest of the individual who may not be realizing it and
therefore undervaluing them. Market often may not be so clairvoyant and that is one
reason today we are talking of corporate social responsibility. The State as patron
assumes this role, encourages consumption of such goods, and provides for public
health measures such as inoculation, vaccination, etc. and for basic education. Merit
goods have positive externalities and spillover effect across society and over
generations, is an additional point. By the same token, market may indulge in
production and distribution of de-merit goods (or merit bads) and the State assumes
duty to discourage their consumption, say, of narcotic drugs. Though the action
does interfere with consumer sovereignty, it is considered a well-intentioned
intervention.
The government may have to intervene for the reason of asymmetry of information
between two parties of a transaction, which may lead to adverse selection (typical in
the case of insurance where the insurance companies get bad cases) and/or moral
hazard (where the insured becomes less careful in protecting his/her wealth or health).

14 In addition, the government—particularly the national government, has to monitor

the international economic flows of trade, investment and technology as well as of Welfare Foundations of
Economic Policies
labour and international economic relations—bilateral and multilateral. Whether
protection of local industries is important or that of local consumers will be weighed
and argued and a political economy decision would be arrived at. Whether imports
have to be curbed and how—whether through quantitative restrictions or high tariff
walls, concerns the State, which has to study the external environment. How exports
have to be boosted whether through subsidy at dock or at production/processing
stage is worry for the State, which has again to respect certain international
commitments. All these decisions impact resource allocation and stabilization through
one or the other channels listed above.
Check Your Progress 4
1) Name a few instruments of public intervention and categorize them.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2) What do you mean by joint ventures? How will you designate them as public
enterprise or private enterprise?
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...................................................................................................................
3) List cases of nationalization of industries and financial companies and banks.
...................................................................................................................
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...................................................................................................................
4) List a few financial institutions created by the government to help private ventures.
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5) Why are certain economic ventures not undertaken by the private sector?
...................................................................................................................
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15
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Public Economics : The 6) What do you mean by regulation? Suggest a few regulatory mechanisms which
Basic Concepts
government undertakes to protect consumers.
...................................................................................................................
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7) Why should redistribution of income and wealth be an agenda of the government?
Suggest a few programmes undertaken in India.
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8) What is a merit good and what is the role of government in its provisioning?
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1.5 ROLE OF GOVERNMENT IN A MIXED

ECONOMY: CHANGING PERSPECTIVE
Since mid-seventies of the century gone by, a new wind is blowing across the world
as one started in the aftermath of Second World War. With dismantling of Soviet
Russia in the late 1980s, a further impetus to private sector activities and a final blow
to public sector intervention became visible. On the one hand fiscal mismanagement,
chewing more than what it could swallow, became rampant everywhere while on
the other the pressure for which welfare measures were undertaken was now absent.
Phrases like, ‘Government has no business to be in business’ and ‘Downsize the
government’ ranted the air in the early 1990s. Though some held that not the size but
the complexion of the government has to change. But there were echoes of
dismantling or radically reforming the idea of welfare state. Direct intervention started
giving way to indirect intervention and reduction in magnitude of indirect intervention
was being sought, reduce tax rates and do away with subsidies. Ethos was the
following. Not production but provisioning was the proper role of the government;
not production but regulation was the proper role of the government. A double test
has to be applied for public intervention: if market fails to do something efficiently
whether state can do it efficiently.
We shall use Indian examples to substantiate the above assertions, as they will help
one to relate more easily the change in perspective for the role of government in the
economy.
16
The reasons are not far to seek as far as bulk of public sector undertakings, at least Welfare Foundations of
Economic Policies
by number, are concerned. It seems at the hindsight that some kind of miscalculation
was carried out while setting up many public sector undertakings. It was thought
under the government, they would be able to protect the interest of consumers and
workers both as well as to generate surplus for their own growth. But in many cases
they turned out to be welfare measures for workers rather than operation of
commercial ventures. Instead of generating any surplus they became dependent on
the government for their survival even while they were running as parastatals. Their
denationalization was sought. First, loss-making ones were to be sold to the private
parties who did not show much interest. Soon, virtues of privatization were counted,
notwithstanding of shining examples of some of the public sector undertakings,
navratnas and mini-navratnas, existing particularly in oil sector. Partly, control of
fiscal deficit needed disinvestments. Nationalisation was replaced by privatization.
But we must remember that part of the reason for failure of public sector undertakings,
particularly those belonging to the states, was the lack of role clarity and the patronage
of politicians/bureaucrats, who were at helm of affairs instead of professionals.
Public intervention was not sought only for controlling and regulating private sector
but also for promoting its interests. The government set up joint ventures with smaller
houses. Cooperation of public sector was sought by private sector. Actually, neither
public sector nor private sector was disallowed to interact with the other. They
purchased material or services from each other. But today the wind is blowing in the
other direction. Slashing of government equity and replacing it by private equity
(through banks, mutual funds, corporations and individuals) in various proportions
(26%, 51%, 74%) has been suggested. Though there continues to be a suggestion
to keep certain well-functioning like BHEL or NTPC within the public sector so that
some benchmark is available for private sector.
Unbundling of services and involving private sector wherever possible is the new
trend. It is also being suggested that cooperation of private sector should be sought
in public activities like public works, public utilities, infrastructure, etc. A variety of
modes of public private partnership right from outsourcing/contracting out to opting
out have been suggested depending upon the level of government and the sector. In
any case the government is moving from position of direct provider to purchaser of
services. Yet, public firms for their survival are now trying to contract in private
services.
Financial sector, which was promoted and regulated by the government, came to be
under scanner for its lackluster performance. It was suggested that this sector should
be made open for private capital and foreign capital. Banking and insurance business
are now open subject to general guidelines from the RBI. Earlier the Controller of
Capital Issues (CCI) controlled the capital issues. After recommendations of the
Narasimham Committee on Reform of Financial System in India (1991), the post of
CCI has been abolished. Instead, Securities and Exchange Board of India was set
up and is being strengthened as a regulatory body to oversee the functioning of
capital market, for example to prevent scams and to encourage initial public offers.
Similarly, Insurance Regulation and Development Authority (IRDA) is the agency to
oversee the working of insurance business, which is now open for private sector.
Fiscal reforms have been underway for over two decades. Rates have been slashed
down, slabs have been cut down and procedures have been simplified, whether it is
direct tax (personal income or corporation income) or indirect tax (excise or
customs). Service tax has recently been introduced. It has been found that absolute 17
Public Economics : The revenue has substantially risen. Credit goes partly to reforms encouraging compliance
Basic Concepts
and partly to good performance of the economy. Cash subsidies, which have been
substantial, have drastically come down; other subsidies are getting exposed whether
it is electricity to poor or irrigation to farmers. States are following the Centre. VAT
(value added taxation) is getting implemented in most of the states. New public
investment is on wane but current expenditure is on rise. Maintenance of assets is
now being given better care so that they are better utilized.
Local governing institutions have come in place and their role is being enlarged.
Despite rhetoric of transfer of functions, functionaries and funds, not much is getting
done. People are demanding devolution of power rather than decentralization of
functions.
Some of these reforms are results of globalization and decentralization.
These are examples, which suggest that wind is blowing for government to enable
rather than to control.
The trends, in short, seem to be lessening of direct control by the government,
withdrawal of government from production sphere except in strategic areas, seeking
partnership with private sector in development of infrastructure, withdrawing subsidies
but spending more on social sectors, decentralization of governing system and
globalization of the economy.
Check Your Progress 5
1) List major weaknesses of public sector enterprises.
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...................................................................................................................
2) Cite cases of public-private partnership.
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...................................................................................................................
3) List some financial reforms.
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4) List some fiscal reforms.
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18 ...................................................................................................................
 ................................................................................................................... Welfare Foundations of
Economic Policies
...................................................................................................................
5) What are the new trends about the role of state?
...................................................................................................................
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...................................................................................................................

1.6 LET US SUM UP

In this unit, we have broadly hinted at the deep connection that lies between economic
policies and welfare considerations. We have tried to delineate the province of Public
Economics and underline the broad contours. We have extensively dealt with the
concerns of Public Choice Theory, which are more about behavioural patterns of
different actors from voters to policy makers and bureaucrats to political executives.
We also discussed the role of government in the economy as well as how the
perspective and paradigm in which the governments work has of late been changing
and is further changing.
We have also given below two enriching Appendices—one on public intervention
and the other on mixed economy, with the hope that you will enjoy reading them and
benefit from reading.

1.7 KEY WORDS

Banks : Commercial banks are a variety of financial
intermediaries that accept checqueable
deposits and loan our primarily to commercial
enterprises. Central bank on the other hand
control money supply and credit conditions
and supervises/regulates operations of the
financial system.
Capital Market : Markets in which financial resources like
money, bonds and stocks are traded. Capital
markets and financial intermediaries transfer
resources from savers to investors.
Direct Taxes : Taxes levied on individuals and firms, the basis
being income or profit or wealth.
Efficiency : (Allocative) efficiency is about of absence of
waste. The condition of maximum possible
production/consumption from given resources
and technology is termed as efficiency.
Externalities : Externalities are external economies/
diseconomies emanating from an activity,
affecting others who have nothing to do with 19
the activity.
Public Economics : The Fiscal policy : Use of taxes and non-tax instruments to
Basic Concepts
defraying the cost goods and services and
making transfer payments so as to influence
allocation and distribution and to ensure
stabilization of the economy.
Foreign Exchange : Also called forex in short, is the availability of
currency or other financial instruments of
foreign countries to help settle the dues and
obligations to them.
Free Trade Policy : A policy of non-intervention in trade between
countries by tariff, quota or other means.
Game theory : An analysis of situations involving two or more
decision makers, having conflicting interests
(even if partially), where payoffs are product
of mutual interactions. Games, war, bargain,
and diplomacy are all situations of game
theory.
Indirect taxes : Taxes levied on goods and services, the basis
being manufacturing, purchase/sale (including
imports/exports).
Inflation : Generally refers to per centage increase in
general price level. Point-to-point inflation rate
refers to per centage increase in price level in
a given week/month this year over the price
level in the same week/month last year.
Insurance : A system of spreading and sharing of risk of
losses through which individuals can reduce
their exposures to risk by participating in the
system in large number.
Laissez-faire : Literally means leave us alone. It is a view
that government should interfere with the
market forces as little as strictly needed. The
government should undertake maintenance of
law and order, national defence and such other
public goods as the private business would
not undertake.
Macroeconomics : Analysis dealing behaviour of economy-wide
aggregates such as national income,
unemployment, price level, foreign trade,
money supply, etc.
Market failure : Imperfection, chiefly owing to presence of
externalities and imperfect competition, in the
price system preventing efficient allocation of
resources.

20
Median : The middle-most value in a sequenced order
of values.
Microeconomics : Analysis dealing with the behaviour of single/ Welfare Foundations of
Economic Policies
individual elements such as a product or a
business firm.
Monetary Policy : Operations of the central bank for exercising
control¯through discount rate, reserve
requirements, liquidity ratio and adequacy
ratio-over money, interest rate and credit
conditions.
Moral hazard : An incentive for somebody to behave in a
non-judicious manner. For example, increase
in likelihood of non-locking of car because of
insurance against the risk of theft.
Natural monopoly : A technological situation in which one single
firm is capable of supplying service for the
entire demand while its average cost curve
continue to decrease.
Patent : An exclusive right granted by the State to an
inventor for a limited period to exercise
control over its use. The right can be sold/
purchased and inherited like any other
property.

Public choice : The theory that deals with the ways

governments make choices to direct the
economy through incorporating behavioural
assumptions about various actors involved in
the process.
Public good : A good with benefits indivisibly spread
through the community irrespective of
whether particular individuals desire to
consume.
Regulation : Government laws or rules and mechanism to
control behaviour of economic actors.
Regulations affecting entry, price or service
are called economic regulations while those
attempting to correct externalities such as
pollutions, are known as social regulations.
Risk : Variability of the returns on an investment.
Tariff : A tax imposed on each unit of goods imported
into a country.
Welfare State : A State which runs on market principles but
regulate social conditions by providing social
safety net.

21
Public Economics : The
Basic Concepts 1.8 SOME USEFUL BOOKS
Bailey, Stephen J., Public Sector Economics, Macmillan, 1995.
David A. Starrett, Foundations of Public Economics, Cambridge University Press,
1988
Donijo Robbins (ed.), Handbook of Public Sector Economics, Taylor & Francis,
2005
Danis C. Mueller, Public Choice, Cambridge University Press, 1979
Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and
Practice, 1990
William F. Shughart II and Laura Razzolini (ed.), The Elgar Companion to Public
Choice, Edward Elgar, 2001
Kurien, C.T., The Economy: An Interpretative Introduction, Sage, 1992.
Halm, G.N., Economic Systems, Vakils, Feffer and Simons, 1971.
Ebenstein, William, Today’s Isms, Prentice-Hall,

1.9 ANSWER OR HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1
1) Because in most matters, issues of efficiency and equity-two chief ingredients
of welfare economics-get involved.
2) Ratio of Public Expenditure to GDP.
3) Standard of weights and measures, coinage, property right laws, use of fiscal
instruments, use of monetary policy, production in Public Sector etc.
4) Differences between economy, nature of states, choice of people, level of
development.
Check Your Progress 2
1) Public intervention in the economy.
2) Go through last two paragraph of the section.
3) Activities, sectors, firms, section and persons compete for limited resources.
Public intervention would modify allocation and distribution.
4) Growth, employment, foreign exchange, price level and rate of interest etc. are
the parameters which may need to be kept at within a narrow band.
5) Macroeconomic intervention particularly involving monetary variables.
Check Your Progress 3
1) Choices arrived at in elections and in deliberations of public bodies.

22 2) Both are collective choices. There is some difference of opinion. Yet the chief
difference between the two is about actors and forums. Use fifth paragraph.
3) Unanimity, consensus, majority votes, pre-rogation. Welfare Foundations of
Economic Policies
4) Candidates/options are ranked in plurality voting. In case, nobody gets votes
more than 50 per cent, in counting of first preference, second preference is
counted. The process continues until some one scores just more than 50 per
cent. In the point voting, cardinal numbers out of a total (say 100) are assigned.
The points are counted for deciding the winner.
5) It is the preference of median voter in an ordered sequence of options that wins
in the simple majority rule. However, it will work only when individual
preferences are single-peaked.
6) Trading of votes across issues between voters is known as logrolling. Strategic
voting involved not voting for most preferred option for strategic reasons.
7) It is assumed that they have short-term horizon.
Check Your Progress 4
1) Write a few instrument of your choice ranging from tax on cigarette to minimum
Wage Act and use paragraph 1.
2) Participation of Public and Private sector.
3) Coal, steel; LIC, GICs, RBI, SBI, PNB etc.
4) IDBI, SIDBI, NABARD.
5) Huge capital and huge risk.
6) Regulation of entry, exit, output, prices. Take a case of road transport (bus and
auto) to see how government tries to protect consumers.
7) Left to market forces, distribution of income and wealth may create a great
chasm between different sectors, which may not good for the health of the
economy.
8) Merit good is one which is primarily a private good but may have extensive
positive externalities. Government encourages its consumption by making it
freely available or by making it freely available or by subsidizing its purchase.
Check Your Progress 5
1) Inefficient operation and dependence on government for survival.
2) Use your own knowledge gathered from local newspaper.
3) Banking, SEBI, IRDA, etc.
4) Direct and Indirect taxes, disinvestments in public enterprises, MOV.
5) Use the last paragraph of the section.

1.10 EXERCISES
1) Why would public intervention differ from economy to economy?
2) Which kind of public intervention is not still considered a part of Public
Economics and Why?
23
Public Economics : The 3) Why are bureaucrats interested in projects that have large expenditure in the
Basic Concepts
present?
4) What is a merit good and what is the role of government in its provisioning?
5) What are the new trends about the role of state?

APPENDIX 1.1 PUBLIC INTERVENTION

We have already indicated in the main text what is meant by public intervention and
why it is resorted to. We intend to further dwell on what it is and what are the
theoretical arguments advanced for application of what goes also by the name of
state intervention or government intervention. We shall also touch upon rather briefly
on weaknesses and pitfalls of government intervention.
Intervention and Inference
First, we must distinguish between intervention and interference though the two words
in this context are interchangeably used. Intervention is considered desirable and
sought whereas interference is considered undesirable and is resisted. It is possible
in certain circumstances that what one party thinks is an intervention, is considered
by the other as unnecessary interference. For example, Bombay Plan chalked by
industrialists invited the State to come forward to set up basic and heavy industries
and to generate electricity and to make provision for education and health. It was
considered a desirable intervention in the economy and the market. Government
promotion councils are still welcome. Today, requirement of license for setting up an
industry or increase in capacity and reservation of certain items for small sector are
considered an encumbrance by many private parties. High taxation rates or rigid
labour laws are considered by certain sections as impediments and hindrances in the
development of certain businesses. These are considered as intervention by many,
including the government, but interference by some of the non-government quarters.
Public Policy Making
Second, public policy is the highest level of intervention, which is administered through
various levers of government, sometimes through the cooperation of non-government
popular bodies. Public policies in economic sphere are more popularly known as
economic policies. They can take shape of Acts, Resolutions, Statements and
following them rules/regulations and guidelines. These often give rise to establishment
of boards, bureaus, institutions, corporations, committees, commissions, authorities,
appellate, tribunals, etc. to implement, adjudicate or regulate.
Third, public intervention may range from putting ceiling on private holding, acquiring
surplus land with compensation (at market price or price fixed by government) or
without compensation to changing indirect tax on tobacco products, from
constructing dams and rehabilitating people affected by submergence to undertaking
vaccination for infants; and from nationalizing sick mills to giving incentives to
factories for installing smoke arresters. From minimum support prices to farmers
growing certain crops in certain areas to assuring minimum wages for certain
categories of workers, from fixing rentals and call charges for customers and fixing
fees for satellite use to negotiating wheeling charges for transmitting power, from
allotting routes to bus operators to fixing bus fares, from fixing pollution norms to
fixing fare schedule for taxies are some of the examples where economic principles
24 are more applicable. This will give an impression that public intervention is quite
pervasive but it is verily so.
Acts of production, promotion, and provision of goods and services, of regulating, Welfare Foundations of
Economic Policies
controlling, monitoring and banning of economic activities, of taxing certain activities
and subsidizing others, which are intended to alter reallocation and redistribution of
resources, with a view to improving public welfare, may all be called public
intervention. We have not given illustrations of those interventions, which are not of
much economic significance.
Market Failure
But why do we need public intervention? Can’t market accomplish all economic
tasks? Believers in efficacy of market have reasons for suggesting public intervention
in certain cases. They call it market failure to allocate resources in accordance with
the social desirability, howsoever established. They argue that there may be too little
provisioning of primary health and primary education and there may be too much
production of liquor or tobacco. Market can perhaps not determine the amount of
defence that the country may need. It is possible that some monopolist may charge
too exorbitant a price that the benefit may not reach a larger population, which it can
otherwise. They have resolved these issues in terms of four factors: (i) existence of
public goods/bads, (ii) existence of externalities, (iii) existence of natural monopolies,
(iv) existence of merit/non-merit goods and (v) asymmetry of information between
two parties of a transaction.
Public goods are the goods characterized by non-rival consumption and non-
excludability of consumers. Non-revelation of individual preference and possibility
of fee-riding makes it a fit case for provisioning by the state and funding by general
taxation. Defence at national level and streetlight at local level are best examples.
Externalities denote impact on a third party – neither producer nor consumer - who
is forced to ride. There could be good externalities and bad externalities: perfume is
liked by a third party and detested by him/her. This existence of externalities creates
wedge between social cost and/or between social benefit and private benefit. To
close this gap, public intervention may be needed through internalization of third
party cost/benefit. Public goods are extreme examples of positive externalities.
Monopolies could be artificial or natural. Artificial monopolies are created by barriers
to entry through necessity of licenses and permits or due to existence of intellectual
property rights like patents or even huge capital requirements for setting up a
competing firm. Natural monopolies on the other hand arise due to technological
advantage whereby all existing demand may be met at declining marginal cost curve.
Cost for marginally extra production in existing unit would be far lower that in a new
unit and therefore new unit cannot come into existence. But application of marginal
rules would result into too little production and too high a price (which are socially
inefficient). Public intervention may be needed in such cases, either for taking up
industry within public fold or for regulating it for price.
Society may have reservation on individual’s choice even in the matter of consumption
of private goods. Parents often advise their children for consumption of milk who
often do not want it and admonish them for smoking which they may be loving. First
is the example of merit good and the second is the example of merit bad or demerit
good. Public intervention may be needed for encouraging consumption of primary
education, health supplements, vaccination/inoculation, which is in the interest of the
individual in the long run. It may also be needed for curbing consumption of narcotic
drugs, which is not in the long run in the interest of the individual consuming them.
These private goods have externalities in a wider context: for example, consumption
25
Public Economics : The of narcotic drugs may lead one to commit crimes or create nuisance. The State may
Basic Concepts
undertake measures of compulsion for consumption and/or provide information. It
may subsidize consumption of merit goods and heavily tax non-merit goods.
There may exist a kind of asymmetry of information between two parties of a
transaction like employer and employee, consumer and seller, insurer and insured.
This phenomenon often gives rise to two problems of adverse selection and moral
hazard. For example, insurer of health may not know well enough of the health
condition of the people seeking insurance and may charge in excess and yet well
end up with people with bad health. The same may happen with the employer who
may not know well enough about the employee despite a lot of filters he puts up.
Moral hazard is the phenomena of carelessness with insured of a property for its
protection from the phenomenon of insurance like fire or theft. Similarly a buyer of
an appliance may care little less if he has got warranty on an appliance for a period.
State Failure
The idea of market failure is fairly old but for quite some time people have been
talking of state failure. If we rollback the state intervention, it only suggests that this
intervention made the things worse in certain sectors. Theory of state failure is still in
infancy except about the rent-seeking behaviour of public officials. But phenomena
of corruption, bribery, bureaucratic delays and lobbying are well known. It was
found that people could get import licenses for consideration and could sell them at
a premium to others who wanted one but could not get. So, solving scarcity through
licensing made it still worse. The activity in which such people are engaged is called
directly unproductive activity, which is actually a social waste.
The government is often found to overspend than is needed. It often covers the
areas it ought not to. In view of some economists, the government carries out ideas
also badly. Omnipotence and omniscience of the State is melting away and so the
omnipresence of the government. People are now talking about x-inefficiency or
organisational slack in the government promoted units and within the government.
State is invited to correct the distortions due to externalities but it seems its intervention
is in far excess of what is demanded. Where pollution tax or incentive to abate
pollution can work to internalize the social cost, the government often enters into
production. Where subsidy can correct the wedge between social demand and
aggregate of individual demands, government can avoid entering to directly do it.
Some of the other reasons are stated to be short time horizons of elected
representatives, lack of hard budget constraints, role of money in financing elections.
Actually, the idea that government is a Leviathan, a monolith monster, is fairly old. It
was suggested centuries ago that government is composed of self-serving politicians,
bureaucrats and professionals, who set out to maximize their own utilities. The idea
may not be very well founded yet there is some truth in it.

APPENDIX 1.2 MIXED ECONOMY

Economy, looking around, seems to be a collection of farms, factories, workshops,
mines and shops; roads and vehicles, railways and rolling stocks, ports and ships/
trawlers and airports and airplanes; banks, investment concerns and insurance houses;
kindergartens, schools, colleges, universities and institutes; cinemas, theatres and
26 multiplexes; spas, hotels and tourist resorts; and dispensaries, health centers, hospitals
and nursing homes. They all produce goods and services, which have economic Welfare Foundations of
Economic Policies
values and are consumed directly or indirectly by the people. They are therefore
constituents of the economy. This description can be likened with the anatomy part
of an organism.
But what is the physiology? Who owns what, who manages what and how, who
works and where and in what capacity, and who monitors and why, are equally
important questions. They deal with the variety of relationships between individuals
and individuals, activities and activities, individuals and activities. While relationships
between activities and activities could be technical, other relationships are of powers,
rights, duties, and obligations. They give rise to certain organising principles called
isms. Slavery, feudalism, capitalism, socialism, and communism are important isms.
That there is some historical sequence in their evolution and that various isms relate
to certain level of development of productive forces, should not detain us here.
State is a big player in any modern economy even if its character mutates with
development of internal forces and interaction with external environment. It influences
and gets influenced by societal forces. But in a formal sense, it gives sanction to
certain relationships and not to others. State always directly played some economic
role. It might have enjoyed direct ownership of farms, ranches and livestock or
owned stocks in commercial ventures besides levying taxes and fees for incurring
state expenses on defence from external aggression and internal disturbances as
well as for meeting welfare expenditure. But its expanse has been enlarging absolutely
and relatively. There might have been times of reversals in history and at this juncture
one finds that there is some rollback of the stance and some redefinition of the role
it should play. But it goes without saying that in most of the so-called civilized
societies, numerically accounting for more than 95 per cent of the humanity, the
State has been in existence since long and equally true is the fact that along with
market and State, many non-market and non-State institutions (caste panchayats
and chaupals in rural areas; clubs and resident associations in urban areas) are in
existence even today. Yet, most of the analysis is conducted in terms of State and
market, and public and private dichotomies.
Not only are mixed economic systems possible, says Halm, but in practice all
economic systems are mixed in the sense that real market systems contain elements
of control and planning and real planned systems use markets and monetary
accounting procedures. Halm wrote so in 1951 when socialist economies existed
and capitalist economies tried a few elements of socialist economies. He wrote that
complete free market economies and totally planned economies are extremes, which
exist in theory only. Yet there is no fixed boundary between the public and private
sections of the economy.
Mixed economy is not a very old term but it triumphed over others like dual economy
or controlled economy. It generally suggests the coexistence of public and private
sectors/spheres/ sections side by side. (Sector, sphere and sections may not mean
the same thing). But people understand that there is some interaction between the
two. However, within this broad understanding there exists a whole spectrum. For
us in India, it generally meant coexistence of publicly-owned enterprises and privately-
owned enterprises. This is what our Industrial Policy Resolutions/Statements
suggested. There were industrial spheres exclusively reserved for public sector,
exclusively reserved for private sector, spheres where both could exist or new
enterprises could be in public domain only. But agriculture farms and small business
could all be private though there could exist certain regulatory mechanism. There 27
Public Economics : The existed private banks and financial institutions side by side but many of them were
Basic Concepts
later nationalized or some were created in public sphere only.
In a wider context, we see that the term has been used with different nuances. A few
of them are as follows. Mixed economy is one in which some production is carried
out by private sector and some by the State in state-owned enterprises. It is one in
which certain activity sectors are left to private ownership and for free market
mechanism and others have significant government ownership and government
planning. It is a combination of market and command economy systems where market
forces control most of consumption goods while the government direct industries in
need areas. It contains private ownership of means of production, infrastructure and
institutions in which the State also owns some of these. It is a system in which private
economic freedom is mingled with centralized economic planning for intervention in
the areas of environmental problems and social justice. Then, it is asserted that an
economy, in which capitalistic and socialist elements both exist, is a mixed economy.
In some other descriptions, existence of mixed ownership of industries has also
been suggested. It can then be accepted that the term mixed economy was coined
to identify economic systems, which stray from the ideals of either capitalism or
various command economies.
Undertaking of welfare and social security programmes in the West, it may be noted,
was the response of the State in the wake of Great Depression and similarly movement
towards the direct control of certain industries was, again, in the aftermath of Second
World War. Public intervention in a more direct manner began in many Asian and
African developing countries after their liberation from foreign yoke. They chose a
middle path because they wanted western democracy sans its capitalist mode of
development and Soviet socialist approach sans its political system. Emerging system
was given the name of mixed economy.
Later, it was found that many economies, which earlier called themselves free
enterprise market economies, chose to call themselves as mixed economies. As a
result, Cuba and America both call themselves as mixed economies but they are
surely different. So much so that Samuelson and Nordhus, and many others like
them, assert to define mixed economy as one, which primarily relies on price system
for economic organisation but uses a variety of government intervention (such as
taxes, spending and regulation) to handle macroeconomic instability and market
failure. That way, most economies were always mixed. They agree and hold that all
contemporary economies are mixed economies. In their understanding, 19th century
England was close to market economy characterized with laissez faire. Though most
decisions are made in the marketplace in the US yet government passes laws
regulating economic life, produce educational and postal services and control pollution,
yet it is said to be a mixed economy. For them, laissez faire is the most important
criterion to characterize a market economy. If it is not a market economy, what else
could it be? Mixed economy! This is how they argue. To many of us, this position is
rather too stretched. However, it is a purely descriptive position.
It is often said that a real system is rarely pure. It can perhaps be not provided status
of an analytical category. Nature of an economic system can be understood in terms
of (a) nature of ownership of means of production whether it is private, public, joint
or separate; (b) nature of motivation whether it primarily profit or welfare; (c) nature
of decision-making whether it is centralized or decentralized, (d) nature of operation
of activities whether it is free price mechanism or administered price mechanism, (e)
28 nature of choice of consumption and occupation whether it is left to the individual or
state apparatus decides about it. One would find that the kind of distinction suggested Welfare Foundations of
Economic Policies
here is getting admixed now. Yet, the virtues of private initiative in capitalism for
profit are well recognized and so is freedom of wage labour to choose occupation
or unionize. But it is rarely trusted for social interest. Even before the Great Depression
it was recognized even by Keynes that enlightened individual self-interest might not
always operate in the public interest. Therefore, doses of public activities beyond
intervention in existing market were conceded. Still different economies will have
different specifics. Britain may have free capital market but may intervene in labour
market whereas in other economies it may be the other way round.
However, let us note that Ludwig von Mises objected to the suggestion that it is a
mixture of capitalism and socialism, as, in his view, operation of capitalist economy
precludes existence of socialist economy. Since State-owned enterprises are subject
to market forces as government may tax citizens to subsidise losses but taxes exert
a market force, existence of State enterprises could at most be a way to socialism
but not socialism.

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