Role of Government in Economic Systems

The shortcomings of the free market mechanism under which there is no role of government in the
economic development of a nation.

Due to the failure of the free market mechanism, the intervention of government became
indispensible for the growth of an economy.

Now, the question arises of determining the extent of government in regulating and managing
economic activities.
This remains a debatable issue among various economists. This is because of the reason that the
government intervention is also not able to eradicate the economic problems of a nation completely.
Different economists have given different viewpoints for the role of government in an economy.
Following are some of the viewpoints given by different economists:
According to Colin Clark, “The role of government must be held at a ceiling of 25 per cent of the
national income.”
According to Samuelson, “There are no rules concerning the proper role of government that can be
established by a priori reasoning.”

From the aforementioned viewpoints, it can be concluded that the accurate and exact percent or
amount of government intervention in an economy is hard to decide and calls for an issue of collective
social choice. The extent of role of government differs in different economies. An economic system is
a way through which economic resources are owned and distributed.

On the basis of the ownership and distribution of resources, the economic system can be grouped into
three categories, which are shown in Figure-1:

Different types of Economic System

Let us learn about the different types of an economic system (as shown in Figure-1).

Capitalist Economy:
A capitalist economy refers to an economy that works on the principle of the free market mechanism.
It is also termed as laissez faire system. In a capitalist economy, the role of government is very limited.
The main functions of government, as given by Adam Smith, are to maintain law and order in a
country, make national defense stronger, and regulate money supply. According to Smith, the market
system administers various economic functions. However, over a period of time, the functions of
government in an economy have increased.

In a capitalist economy, the main responsibilities performed by the government are as follows:

a. Developing and sustaining the free market mechanism system

b. Eliminating any kind of restrictions on the working of free competitive market

c. Increasing the effectiveness of free competitive market system through various measures

In the view of Meade, following are the responsibilities of a government in a capitalist economy:

a. Regulating and controlling various economic situations, such as inflation and deflation, by
formulating and implementing various fiscal and monetary measures

b. Controlling the power of monopolistic and large corporations to elude various economic problems,
such as unemployment and inequitable distribution of resources

c. Possessing the ownership of public utilities, such as railways, education, medical care, water, and
electricity, which are required by an economy as a whole

d. Prohibiting discrimination among individuals and providing them equal educational and job
opportunities

e. Limiting restrictive trade practices and power of trade unions

f. Maintaining law and order, administering justice, and safeguarding the freedom of individuals in an
economy

g. Supporting private ventures in an economy

h. Creating central planning body that helps in the development of an economy on a larger scale

i. Handling problems to environment, extinction of natural resources, and growth of population

Therefore, we can conclude that the major role of government in a capitalist economy is to control
and encourage the free market mechanism. In addition, the government should encourage private
ventures for safeguarding the future of an economy.

Socialist Economy:
In a socialist economy, the function of government is entirely different from the function of
government in a capitalist economy. In a capitalist economy, the government acts as a regulatory and
complementary body. On the other hand, in a socialist economy, the government plays a
comprehensive role in almost all economic activities, such as production, distribution, and
consumption, of a nation. In a socialist economy, not only the ownership of private property is
allowed to a limited amount, but the concept of free market mechanism is also eliminated.

The private ownership of resources, in a socialist economy, is changed by state ownership. In addition,
in a socialist economy, the government plans and regulates all the economic activities centrally at a
state level. Moreover, the decisions related to production, allocation of resources, employment,
pricing, and consumption, are completely dependent on the government or its central planning
authority. In a socialist economy, individual’s decisions are totally dependent on the limit decided by
the government.

For example, individuals are given the freedom of choice, but it is subject to the limitations of policy
framework of the socialist economy. The countries in which socialist economy is adopted are China,
Yugoslavia, Czechoslovakia, and Poland. The objective of the government in a socialist economy is
same as in the capitalist economy, such as growth, efficiency, and maintaining justice. However, the
ways adopted by the socialist economy to achieve those objectives are different from the capitalist
economy.

For example, in the capitalist economy, the main force of motivation is the private profit, whereas in
the social economy, the encouraging factor is the social welfare. The socialist way of managing an
economy facilitates the elimination of various evil activities of the capitalist economy, such as labor
exploitation, unemployment, and inequality in the society. This is only the classical view of the
socialist economy.

However, over a passage of time, the scope of socialist economy has also been reduced due to various
reasons, such as prohibition of profits from private ventures, inadequate utilization of resources, and
restrictions on economic development as noted by Union of Soviet Socialist Republics (USSR).

Mixed Economy:
Mixed economy refers to an economy that-comprises the features of both, the socialist economy and
capitalist economy. This implies that working of a mixed economy is based on the principles of the
free market mechanism and centrally planned economic system.

In a mixed economy, the private sector is encouraged to work on the principle of the free market
mechanism under a political and economic policy outline decided by the government. On the other
hand, the public sector, in a mixed economy, is involved in the growth and development of public
utilities, which is based on the principle of socialist economy.

In a mixed economy the public sector comprises certain industries, businesses, and activities that are
completely owned, managed, and operated by the government. Moreover, in a mixed economy,
certain laws have been enacted by the government to restrict the entry of private entrepreneurs in
industries reserved for the public sector.

Apart from this, the government also strives hard for the expansion of the public sector by
nationalizing various private ventures. For example, in India, the government has nationalized several
private banks, which has resulted in the expansion of the public sector. Besides working for the
growth and development of the public sector, the government, in a mixed economy, controls the
activities of the private sector by implementing various monetary and fiscal policies.

It should be noted here that the free market mechanism is actually a form of a mixed economy. This is
because of the reason that in free market mechanism, both the private and public sectors exist
simultaneously. However, public sector in a free market mechanism economy is different from the
public sector of the mixed economy.

In free market mechanism economy, the public sector is responsible to maintain law and order in a
country, make national defense stronger, and regulate money supply. On the other hand the public
sector of a mixed economy is involved almost all economic activities, such as production, distribution,
and consumption. For example, the public sector of an economy, such as India, is based on the
socialist pattern of society.

Introduction to LPG
LPG stands for Liberalization, Privatization, and Globalization. India under its New Economic Policy
approached International Banks for development of the country. These agencies asked Indian
Government to open its restrictions on trade done by the private sector and between India and other
countries.

Indian Government agreed to the conditions of lending agencies and announced New Economic Policy
(NEP) which consisted wide range of reforms. Broadly we can classify the measures in two groups:

1. Structural Reforms
With long-term perspective and eyeing for improvement of the economy and enhancing the
international competitiveness, reforms were made to remove rigidity in various segments of Indian
economy.

2. Stabilization Measures (LPG)

These measures were undertaken to correct the inherent weakness that has developed in Balance of
Payments and control the inflation. These measures were short-term in nature. Various Long-Term
Structural Reforms were categorized as:

Liberalization
Privatization and
Globalization
Collectively they are known by their acronym LPG. The balance of Payment is the system of recording
the economic transactions of a country with the rest of the world over a period of one year. When the
general prices of goods and services are increasing in an economy over a period of time, the same
situation is called Inflation. Let’s understand each terminology in detail

Introduction to LPG: Liberalization, Privatization, Globalization

Liberalization
The basic aim of liberalization was to put an end to those restrictions which became hindrances in the
development and growth of the nation. The loosening of government control in a country and when
private sector companies’ start working without or with fewer restrictions and government allow
private players to expand for the growth of the country depicts liberalization in a country.
Objectives of Liberalization Policy
 To increase competition amongst domestic industries.
 To encourage foreign trade with other countries with regulated imports and exports.
 Enhancement of foreign capital and technology.
 To expand global market frontiers of the country.
 To diminish the debt burden of the country.
Privatization
This is the second of the three policies of LPG. It is the increment of the dominating role of private
sector companies and the reduced role of public sector companies. In other words, it is the reduction
of ownership of the management of a government-owned enterprise. Government companies can be
converted into private companies in two ways:

By disinvestment
By withdrawal of governmental ownership and management of public sector companies.
Forms of Privatization
Denationalization or Strategic Sale: When 100% government ownership of productive assets is
transferred to the private sector players, the act is called denationalization.
Partial Privatization or Partial Sale: When private sector owns more than 50% but less than 100%
ownership in a previously construed public sector company by transfer of shares, it is called partial
privatization. Here the private sector owns the majority of shares. Consequently, the private sector
possesses substantial control in the functioning and autonomy of the company.
Deficit Privatization or Token Privatization: When the government disinvests its share capital to an
extent of 5-10% to meet the deficit in the budget is termed as deficit privatization.
Objectives of Privatization
 Improve the financial situation of the government.
 Reduce the workload of public sector companies.
 Raise funds from disinvestment.
 Increase the efficiency of government organizations.
 Provide better and improved goods and services to the consumer.
 Create healthy competition in the society.
 Encouraging foreign direct investments (FDI) in India.
Globalization
It means to integrate the economy of one country with the global economy. During Globalization the
main focus is on foreign trade & private and institutional foreign investment. It is the last policy of LPG
to be implemented.

Globalization as a term has a very complex phenomenon. The main aim is to transform the world
towards independence and integration of the world as a whole by setting various strategic policies.
Globalization is attempting to create a borderless world, wherein the need of one country can be
driven from across the globe and turning into one large economy.

Outsourcing as an Outcome of Globalization

The most important outcome of the globalization process is Outsourcing. During the outsourcing
model, a company of a country hires a professional from some other country to get their work done,
which was earlier conducted by their internal resource of their own country.

The best part of outsourcing is that the work can be done at a lower rate and from the superior source
available anywhere in the world. Services like legal advice, marketing, technical support, etc. As the
Information Technology has grown in the past few years, the outsourcing of contractual work from
one country to another has grown tremendously. As a mode of communication has widened their
reach, all economic activities have expanded globally.

Various Business Process Outsourcing companies or call centres, which have their model of a voice-
based business process have developed in India. Activities like accounting and book-keeping services,
clinical advice, banking services or even education are been outsourced from developed countries to
India.

The most important advantage of outsourcing is that big multi-national corporate or even small
enterprises can avail good services at a cheaper rate as compared to their country’s standards. The
skill set in India is considered most dynamic and effective across the world. Indian professionals are
best at their work. The low wage rate and specialized personnel with high skills have made India the
most favorable destination for global outsourcing in the later stage of reformation.