Since the day when the market came into being, it has maintained routine operations and developed day by day with its inherent mechanism. Every participant in the free market makes transactions with others for the sake of his own interests. Owing to this everlasting principle, slowly, market naturally develops various market regulatory mechanisms. Following these natural formed mechanisms, the market performs free and well, as if there is an invisible hand[ ] to dominate and control market participants, guide participants to perform according to the law of the market, make the allocation of scarce resource to be most reasonable, drives consumers and producers make rational decisions and act to pursue wealth.
However, in some cases, free market economy results in blindness, uncertainties and other issues brought failures to achieve market efficiency and therefore advocate active policy responses by the public sector. That is the potential for government to provide macro-controls. But how much should the government intervene with the market and what is the exact proper role of government in the market economy? To explore this issue precisely, I developed this paper into five main sections:
First I introduce the main economy systems and briefly explain the government position in every kind of economy system.
The second part is explicitly dedicated what and who are the government which I believe will help to better understand the role of government in market economy.
In the third part, I briefly talk about the key reasons for governments participation in market economy. More detailed causes for government intervene will be discussed later along with the interpretation of each role of government.
Fourth, in the most vital part, I elaborate perceptions about the role of government. Including the definition of every role and acts that government takes in accordance with different roles.
The paper concludes with the briefly mention of public failure and the emphasis on the relation between government intervention and free market force.
2. Three main economy systems.
Market economy relies on market force like supply and demand law; it allocates resources through decentralized decisions of many firms and households as they interact in market for goods and services [ ]. Completely, there is no governmental intervention.
On the contrary, Planned economy is an economic system in which the state or government manage the economy [ ]. In this system, the central government plans all the economic development, so it got that name. China used to be a country adopted planned economy system during the early years, but before long, China abandoned planned economy system and developed into the system that combines the planned economy and the market economy, after years of development, it is proved that the mixed economy system is best for China to flourish
So whats the mixed economy? It is a combination of free market economy with government intervention, in mixed economic system, there are mixed economic activities, some of them are undertaken by private firms, others are undertaken by the government [ ]. In fact, most country of the world, no matter it belongs to socialism country or capitalism country, has the mixed economic system, even though some of them only use government to fix market failure. But the degree of government intervention is far from the same among different countries; actually, there is no universal agreement on the best proportion for government in mixed market in terms of the well-being of the whole nation.
Its obvious that mixed economy is in the dominant place. In essential, market economy interact with government intervention results in mixed economy, so it is necessary and important to figure out what is the proper role of government in the market economy. Before response to that question, first let me introduce what and who is the government.
3.1 The introduction of government
The government is referred to an organization that is established in the area of a country, through political or legal process, through which a political unit exercises its authority, controls and administers public policy, and directs the actions of its members or subjects. In particular, government refers to a civil government of sovereign stat which can be local, national or international [ ].
With the mandatory and monopoly right, and with the power to prescribe, the power to force people take compulsory actions, and punish, it is the government who should be responsible for national defense, social security and stabilization, thus guiding people to pursue the harmony society.
3.2 The introduction of public sector
The public sector consists of many organizations that designed to deal with public allocation of goods and services. Typically, the government plays a vital role in public sector, yet as it is known public is contrary to private, in public sector, goals are always the well-being of the whole nation, not well-being of any certain citizen.
In term of market economy, a small public sector is developed, with the government being relegated to protecting property rights, setting up the framework for transactions including enforcing laws, regulations and orders, sometimes acting as a direct actors in market economy [ ].
What the government should do in market economy and what is the appropriate size of public sector is over debated for years and there is no prevalent accepted answer to it. Later in this paper, I dedicate myself to interpret roles of government based on my own cognition and comprehension, and I have to say it is just one way to explore in this issue.
4. Summary the potential causes for governments intervention
4.1 Market failure
It is widely recognized, the market economy is led by an invisible hand to promote an end which achieves the private economic efficiency as well as social efficiency. According to Pareto, a resource allocation that has the property that no one can be made better off without someone being made worse off is said to be economic efficient [ ]. Narrowly speaking, the market is efficient basically under two conditions: the markets are perfectly competitive and there are only buyers and sellers affected by the outcome of market matters. However, competition is sometimes far from perfect in the real world and most of times the market transaction has externalities that affect the stand-by as well. In general, we call all this kind of phenomena market failure, which prevent achieving market efficiency.
Even though the invisible hand [ ] of the market place leads market participates (producers and consumers) in a market to maximize their own gain form transactions, at the same time maximize the total benefit that society derives from the market, it can not guarantee a resource allocation be equitable. Moreover, difference in educational opportunities, endowment, born property ownership and rights all result in further inequity in the society. It has already been proven that society inequity would lead to violence and even social instability, eliminating or at least reducing the inequity is no doubt indispensable. Given the government characteristics and powers, it seems government is the best suitable one to deal with inequity.
4.3 Irrational people
In market economic, the rational consumer is referred to the one who makes the best use of his information and skills in an effort to maximize his profit through financing wisely [ ]. It seems to be human nature to spend money wisely, however, nowadays many societies and individuals have failed to distinguish the difference between a want and a need. Sometimes people are myopic and limited in cognitive ability, information and the finite amount of time they have to make decisions. In consequence, people get satisfactory solution rather than the optimal one.
Because of all these, there is tragedy of commons, there is the need for merit goods, and there is the need for government to intervene.
5. The roles of government in market economy
5.1 The government as economic actors
Governments, no matter are central government or local governments, one of their roles is acting as economic actors, namely, directly involve in economic activities. In detail, the role as economic actors can be explained in four aspects:
5.1.1 The government as owner
Government exits as an owner in domestic economic system. To manage and supervision the state-owned assets is an important duty of the government. Here I give some examples of government ownership.
First of all, government is the land owner. In China, all lands are owned by the government, and individuals only have some right to use the land. According to the Law of the Peoples Republic of China on Land Contract in Rural Areas [ ] which came into force in 2002, August 29th, people are able to contract a land for maximum 30 years and in terms of commercial housing, the rights of using land last for 70 years.
Second, it is the owner of capital, public capital such as Public roads and bridges, Public parks and squares, Public cemeteries, Government office buildings, and National defense facilities [ ].
Third, government owns some Educational institutions, ranging from kindergartens to Public University, public libraries, museums, theatres etc [ ]. Most of these assets are served for social purpose instead of for making profit, government operates them mostly aiming at promoting the well-being of the whole society. In addition, there are some Health-care and social institutions also serve the same purpose, such as public hospitals, district medical surgery, clubs for old peoples, places for social employment.
Forth, government also owns some enterprises that perform just as the private enterprises, for this respect, government also as a producer that provides people with commercial goods, which will be discussed next.
5.1.2 The government as producers and providers.
When government acts as producer, it provides social welfare programs, public goods, public services, and as well as commercial goods.
First, owning the private-like enterprises, government is able to produce electricity and sell it to consumers [ ], waters and other necessity commodity for living. In China, government also operates the post offices and telecom company, which provides the communication infrastructures and services [ ].
Second, in terms of social welfare programs, government provides services and goods that can not be provided by the private sector based on that people are self-interested and are not aware of responsibility for these kinds of things. For instance, The Aid to Families with Dependent Children is a program that assists families where there are children but no adult able to support the family; The Supplemental Security Income which help the poor and disabled to survival when necessary [ ]; The medical care programs aid the aged to enjoy subsidized medical treatment[ ]. These kinds of services can not only be provided directly by government-owned organizations, but also to be provided indirectly through companies and organizations engaged by the president to provide services to the community.
Third, the government provides public goods which can not be provided by private market efficiently. Public goods are neither excludable nor rival [ ]. The term non- excludable means that no one can be excluded by utilizing the public goods, and the term non-rival implies that any additional one to enjoy the public goods do not affect the enjoyment for public goods of others. The most commonly governmental provided public goods are national defense, basic research and fire protections.
5.1.3 The government as employers
Obviously, government itself as an organization serves many jobs to labor offers. In China, there are about 6 million government officers [ ], so it let many people employed. Whats more, government owns substantial enterprises, surely they provides plenty of jobs. Every society has a problem named unemployment, government acts as an employer is one important way to help ease the problem.
5.1.4 The government as consumers
Sometimes government can not produce goods and services needed to serve the public, so it act as consumers, buying good and services from the market [ ].
5.1.5 Why government acts as a direct economic actor
To sum up, governments as direct economic actors, operate state-owned enterprises, consume and produce commercial goods, provide public goods and services. Since the competitive market can achieve Pareto efficiency itself, why there is need for governments participation as a direct economic actor?
As I mentioned before, there are market failures which leave space for government to tamper with the private market. One particular failure is the under-consumption or under-supply of public goods by the free market [ ]. This failure directly calls for the government intervention, implies the potential for government to act as direct economic actors like providers and owners.
Let me take basic research as an example to explore into this role of the government. Basic research is one kind of public good because it is non-rival and non- excludable. More specifically, when there is a new theorem developed by a scientist, everyone can enjoy the new knowledge freely, and it makes no difference how many people are learning and using the new knowledge.
Due to the two properties, no one is willing to pay for the basic research since they can enjoy it freely, which is also known as free rider [ ] problem, to solve this problem, someone once proposed that to charge people from using the fruit of research (under the assumption that is possible), in this way, make it excludable but still non-rival, thus prevents some people from enjoying the good even though their consumption for the good would have no marginal cost [ ] which finally result in under-consumption. Once again, private market producer are self-interested, and they will not provide good with no profit, so the free non-rival public good will be under-supplied by the private market.
From the forgoing, the government is required to make the public goods like basic researches to be consumed and supplied appropriately.
Another reason accounts for the direct participation of governments is there exits merit goods. Some of merit goods like old-age insurance [ ] have to be provided by the government, some are not provided but regulated consumes by government, the detail of merit goods will be discussed in the government as a regulator chapter.
Further more, some goods like electricity, water, gas and telecom services, although they are not public goods and people need and most of them are willing to pay for the usage of these goods, they still only can be provided to some extent by the government through state-owned enterprises. The reason for this are more complicated, including not only economic factors but also security factors, as well as political factors. In China, Baosteel, China Telecom and Electricity Company [ ] are all big government-owned enterprises which provide such commercial goods.
5.2 The government as policy maker
Even though the state of government as direct economic actors is gradually abated, the state of government as economic policy makers, especially as macro-controllers is still important [ ]. Given the power and leading role of government in state and society, it is able to set out various economic policies that influence the economic activities to promote economic growth and macroeconomic stability.
The economic policies made by governments can be divided into two main categories, macroeconomic policy and microeconomic policy [ ]. Microeconomic policies are focus more on legislation, regulations on specific economic activities which I would like to discuss later in government as regulator chapter, and here I dedicate myself to exploring into macroeconomic policies such as trade policy, monetary policy and fiscal policy in an effort to see the government role as a policy maker.
Let me take monetary policy as the example. Monetary policy is the setting of the money supply by policymakers usually through central bank [ ], the setting of money includes the supply of money, the interest rate and the control of money in market. It is known that the inflation [ ] (an increase in the overall level of prices in the economy) always happens in the history, to deal with high inflation, government make concretionary monetary policy to reduce the supply of money and lower the interest rate. While on the other hand, when comes to recessions like high-rate of unemployment, government make expansionary policy to simulate the economic development [ ]. Anyway, the government makes monetary policy to find a balance, to maintain the stability of economic development.
Contrasted to monetary policy, there is fiscal policy, which is the use of government expenditure and taxation to influence the development of economy [ ].
Imaging that there is no policy to control money printing and distribution, to guide the overall development of economy, to stabilize the pace of development, nothing will happen except the chaos of market and society. Market economy is not perfect, in history, there was periods of high-level unemployment, fast rising prices, and those period can not be moderate by market itself, thus the government stabilization policies seems to be indispensable.
In addition, every countries economy is not only performance and developing in domestic environment, but also affected by international economic environment. To pursue a health and stable growth of economy and gain a complete victory in international economic, only rely on free market mechanism is not enough, due to the fact that there is not merely economic factor, as well political factors, macro-controls and design policies toward world economy by government is particularly vital.
5.3 The government as redistributors
Through the establishment of social income and wealth redistribution mechanisms, government attempts to reduce the rich-poor gap in a certain range, to promote social stability and to promote community coordinated development as a whole. In my opinion, government as redistributors mainly yields two kinds of distribution: one is the allocation of resources and goods, the other one is the redistribution of income.
First in terms of re-allocation of resources and goods, on the basis of the second fundamental theorem of welfare economics, out of all possible Pareto efficient outcomes one can achieve any particular one by enacting lump-sum wealth redistribution and then letting the market take over [ ]. So when the distribution of resources yielded by the market was not socially acceptable (like irrational consumers make irrational decision, under-supply of public goods, too many negative externalities etc), then all the government needs to do is to redistribute the initial endowment. Through subsidize, taxation and some other methods, government can re-allocate some resources to ease the under-supply of public good, reduce the consuming of some demerit goods and restraint the products accompanied with heavy pollution [ ].
Then, in terms of redistribution of income, market economies may be productive and efficient at producing wealth, but they may also yield a distribution of income where some people become very rich and others starve [ ]. Theoretically speaking, the one with high educational level and skills earns more than the one who is less capable, moreover, the inherited wealth also result in inevitable inequity among society members. Given all this, most economists consider government is the most important role in income distribution.
Although within our society there is some voluntary redistribution [ ], it remains limited and can not solve the serious problem like poverty. To require some one give up wealth to help the one in need, government use its compulsion power to effectuate redistribution mainly through taxation and welfare programs.
In recent years, Chinese government gathers about 350 billion CNY through individual income tax annually [ ]. Some of these money transfer into income to people who have low wage, some transfer to welfare programs. For instance, Compulsory Education Program [ ] ensures the children can attend primary and junior school without paying tuitions, meanwhile government use gathered money as subsidy to provide public schools that ensure there is equality of opportunity in terms of education even to the poor. Other welfare programs like aiding the farmers, unemployment compensation and housing subsides also transfer money to the one needed the most.
5.4 The government as economic regulator
Government, as the economic regulator, manages and standardizes the economic activities in economic markets. That is to say, government can regulate the market production, services, exchanges and consumption through legislation.
First of all, government acts as a market order defender. The prosperity of market economy needs a unified, open, competitive and big orderly market, thus market rules must be sound and order must be guaranteed. So aim of the government is to ensure that the market has its transaction order and performs under the legal framework and guarantee trading taken place in markets where the legal rights of consumers and producers to own and trade economic resources are clearly recognized and protected. For example, it keeps records of deeds to land and houses in market economies, and enforces contracts between buyers and sellers of virtually all kinds of products and set up laws and regulations like the law of contract, which brings people together to do business and the law regarding trespass which are about outlining peoples rights and responsibilities in relation to each other. Briefly to say, governments must establish and protect the right to private property and to the economic gains derived from the use of that property and play as a good market defender.
Second, recalling one of market failures named externalities which describe the situation where the actions of one individual or one firm affect other individuals or firms. In this case, the social cost of producing a good or service equals the private cost plus the external cost of producing it, private costs are less than social cost. Thus, the person or firm responsible for the external cost does not face the full cost of the choice involved, directly result in market inefficiency.
Consider the case of firms that produce paper. The production of the paper generates water pollution. The cost of this pollution is an external cost; the firms that generate it do not face it. These firms thus face some, but not all, of the costs of their production choices. We can expect the market price of chips to be lower, and the quantity produced greater, than the efficient level. Then the government should force the producers and potential consumers of the product to pay these cleanup costs, in essence, instead of considering the marginal cost of the company, we should consider the social marginal cost, this economic role of government is to make those who enjoy the benefits of producing and selling and those who consuming the product pay all of the costs of producing.
Beside negative externalities, there are also positive externalities like new inventions and new development of technology. New inventions will not only benefit the inventor, but bring the whole world advantage as well because all the citizens can enjoy the fruit of society developments. In this situation, government should find some way to encourage the research such as subsidize this kind of work and passing laws to protect patents. Anyway government should act to deal with externalities, only rely on the voluntary market transactions, the externalities can not be internalized, government has to exercise control over private economic organizations to achieve social goals, such as protecting the public’s health and safety or maintaining a clean and healthy environment.
Third, government plays the role of people and social protector. To pursue better health life and more harmonious society needs governments participation. As the result, in some cases, the public sector makes a determination that people should consume more of some goods and services and less of others, even in the absence of market failure.
Lets have a look at merit goods. They are goods which are judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay and they are often under consumed or under supplied. Like primary education, some people are not willing to consume although it is beneficial to them in a long run, meanwhile, government provides compulsory education and force people to receive it. Other examples like seat belt and hard hat also show the fact that people sometimes are myopic and not rational enough.
In addition to merit good, demerit goods also call for the governments intervention. They are goods whose consumption is discouraged by the public, based on a presumption that individuals do not adequately weigh all the costs of these goods and thus should be induced to consume less than they otherwise would. For instance, government has imposed a consumer tax on the cigarettes since the smokes pollute the air and do harm to peoples health. And the consumption of such goods like drugs is prohibited for the sake of saving lives.
Amid these many options, the key point is to understand one of the government’s roles — to correct for the overproduction and overconsumption of goods and services and provide protection to ensure orders of society and well-being of the society.
6. Critical points about the role of government
After examine the exact role of government in market economy, government seems to be an indispensible component of economic system. Nevertheless, public failure as well as market failure is inevitable, including imperfect information and market for public sector, lack of competition within the public sector that further attenuates incentives, fiduciary relationship of government which imposes severe constraints on expenditure patterns and employment policy and etc.
While it is important to recognize the potential gains from government intervention to correct market failure, we must recognize the difficulties inherent in such efforts and stay aware of that the role of government is not to take the place of the marketplace, but to improve the functioning of the market economy. Further, any decision to regulate or intervene in the play of market forces must carefully balance the costs of such regulation against the benefits that such intervention will bring.
To sum up, government mainly plays four roles in market economy: direct economic actor, policy maker, redistributors and regulator. As a direct economic actor, it corrects problems of market failure associated with public goods and manages SOEs to benefit the society; as a policy maker, it sets out various policies that influence the economic activities to promote economic growth and macroeconomic stability. external costs and benefits, and imperfect competition; as redistributors, it redistribute scare resources and income when necessary to promote social stability and to promote community coordinated development as a whole; finally as a regulator, government manages and standardizes the economic activities, deals with externalities and protect people and society.
Although government intervention to correct market failure always has the potential to move markets closer to efficient solutions, and thus reduce deadweight losses, there is, however, no guarantee that these gains will be achieved. And in most of case, the choice between the markets allocation and an allocation with government intervention is always a choice between imperfect alternative.
So no matter what the balance between the public and private sectors is, we have to keep in mind that government is meant to assist free market force to perform in economies, not to take place of market force itself.