Development Economics - Balance between markets and intervention
Terms in this set (33)
Definition of Market-oriented policies
• market-based supply-side policies, including:
policies encouraging competition (deregulation, privatisation and anti-monopoly regulation
labour market reforms
• trade liberalisation (free or freer trade)
• freely floating exchange rates
• liberalised capital flows, or the absence of exchange controls which limit the amount of foreign exchange that can be purchased with the domestic currency
Discuss the positive outcomes of market-oriented policies - summary
1. Allocative efficiency
2. Economic growth
3. Balance in the balance of payments and greater flexibility
4. Persueing foreign exchange and therefore attracting MNCs
Discuss the positive outcomes of market-oriented policies - allocative efficiency
Market-oriented policies are based on the idea that free markets, working under competitive conditions, offer a method to answer the what to produce and how to produce questions of resource allocation in the best possible way. With market-determined prices working as signals and incentives, markets co-ordinate the countless independent decisions of consumers, firms and resource owners, allowing social surplus to be maximised, thus achieving allocative efficiency.
Discuss the positive outcomes of market-oriented policies - economic growth and incentive related policies
The pursuit of self-interest by all economic decision-makers (consumers, firms and resource-owners) gives rise to incentives for hard work, risk-taking, innovation and investment, which lead to higher levels of output (economic growth) and possibly higher standards of living. The operation of markets therefore also promotes general welfare by achieving economic growth.
Discuss the positive outcomes of market-oriented policies - economic growth and policies encouraging competition
Policies encouraging competition, such as deregulation, privatisation and anti-monopoly regulation, which work by freeing market forces and making markets more competitive, are intended to result in greater efficiency in production, lower prices and improved quality, and a better allocation of resources, as well as increased levels of output, or economic growth.
Discuss the positive outcomes of market-oriented policies - economic growth and labour market reforms
Labour market reforms similarly promote free market forces in labour markets, allowing the allocation of resources to improve. Incentive-related policies, involving adjustments to various types of taxes, are intended to work by improving the incentives to work, innovate and invest, thus making the signalling and incentive functions of the price mechanism more effective, again improving the allocation of resources and also allowing for economic growth.
Discuss the positive outcomes of market-oriented policies - economic growth and trade liberalisation
Trade liberalisation is based on the same ideas, and has the same intended benefits. The elimination of trade barriers and the opening up of countries to free trade has the effect of making markets much larger than they would be with trade barriers. The result of larger free markets is to increase competition, increase efficiency in production, lower prices and improve quality, increase consumer choice, improve the allocation of resources, and allow for greater economic growth.
Discuss the positive outcomes of market-oriented policies - balance in the balance of payments and greater flexibility
Freely floating exchange rates are simply another aspect of the price mechanism of free markets. A market-determined exchange rate is one that reflects the forces of supply and demand for a currency, and therefore can effectively carry out the signalling and incentive function of prices (here applied to the 'price' of a currency) for those carrying out international transactions of all kinds. Just as a market-determined price of a good 'clears' the market, so too a freely floating exchange rate automatically adjusts to excess demand or supply of a currency, bringing about a balance in the balance of payments and offering greater flexibility to policy-makers to pursue policies needed domestically.
Discuss the positive outcomes of market-oriented policies - foreign exchange and attracting MNCs
Liberalised capital flows (or absence of exchange controls) allow domestic residents to purchase any amount of foreign exchange without restrictions, whether for imports, or for travel or investment abroad, etc. This is important for attracting multinational corporations (MNCs) because it means the MNC is free to repatriate profits or to purchase inputs from abroad (import them). In addition, free capital flows mean a more efficient global allocation of savings, since savers are free to make financial investments anywhere in
the world without restrictions, in accordance with the expected profitability of their investments.
Discuss the negative outcomes of market-oriented strategies - summary
1. Market failure
2. Co-ordination failures
3. Weak or missing market institutions
4. Development of dual economies
5. Income inequalities
6. Insufficient credit for poor people
7. Questionable effects on economic growth and development
Discuss the negative outcomes of market-oriented strategies - Market failure
One of the most important weaknesses of market- oriented strategies is that they cannot deal with the issue of market failures. While this issue is important for any country, it is of special importance in many developing countries where market failures of all kinds are far more widespread.
Market failures we have studied include:
• negative environmental externalities (of production and consumption) and the problems of common access resources
• insufficient provision of merit goods (goods with positive consumption externalities) including education, health care and infrastructure, such as sanitation, clean water supplies, road and transport systems, irrigation, power supplies, etc.
• failure to provide public goods
• abuse of monopoly power
• information asymmetries
Discuss the negative outcomes of market-oriented strategies - Co-ordination failures
Co-ordination failures provide a possible explanation for the failure of firms to be set up and to contribute to growth. Suppose that firms would be able to increase their output if they began producing in a market requiring skilled labour. However, they will not enter this market if the skilled labour is not available; at the same time, workers will not acquire the skills if the firms that could hire them do not exist. As a result, the firms do not enter this market, and the workers do not acquire the skills. Both the firms and the workers get stuck in a position where they are worse off than they would have been if they could co-ordinate their activities and simultaneously enter the new market and acquire the necessary skills.
Co-ordination failures arise when two or more activities that must begin simultaneously fail to do so, even though decision-makers make economic decisions that are in their best self-interest. The inability of decision-makers to co-ordinate their behaviours results in an outcome where everyone is worse off than they would have been had co- ordination been possible. These failures lead to underdevelopment traps, where people are trapped in a situation from which they cannot escape without outside help.
Discuss the negative outcomes of market-oriented strategies - Weak or missing market institutions
To be able to function effectively, markets need an institutional and legal environment that is often missing in less developed countries (and some transition economies). This environment must include enforcement of property rights, enforcement of legal contracts, effective legal recourse, a stable currency, a well- developed banking and insurance system, an effective road and utility infrastructure system, and readily available information on prices, quantities and quality of goods, services and resources to consumers, firms and resource owners. In the absence of these conditions, markets are highly imperfect in their functions and fail to function effectively.
Discuss the negative outcomes of market-oriented strategies - Development of dual economies
Dual economies may persist even as a country grows and develops. They are the outcome of market forces that do not work to the benefit of all or most people in a country because of the presence of market failures such as weak market institutions or co-ordination failures, because of the geographical isolation of many groups of people, the persistence or growth of great income inequalities and extreme poverty, or government policies that support one sector of the economy at the expense of another.
Like all kinds of market failures that require some government intervention for their correction, so dual economies also require government policies that attempt to eliminate the dualism. The appropriate policy depends on the nature of the dual economy, i.e. whether it involves an advanced agricultural sector together with traditional, subsistence agriculture, or an advanced capital-intensive industrial sector together with a traditional labour- intensive urban informal sector.
Discuss the negative outcomes of market-oriented strategies - Income inequalities
The loss of protection of workers resulting from labour-market reforms, and increases in unemployment resulting from some policies to increase competition, including trade liberalisation which often involves the closure of firms, often result in increases in income inequalities. In addition, the inability of certain groups of people to take advantage of opportunities opened by trade and market liberalisation can also lead to increasing income inequalities.
Discuss the negative outcomes of market-oriented strategies - Insufficient credit for poor people
Poor people do not have access to credit, as the market working on its own does not allow poor people with no collateral and seeking very small loans to acquire the credit they need. This results in lower investment possibilities, greater poverty and poorer income distribution, as well as the inability to escape the poverty cycle.
Discuss the negative outcomes of market-oriented strategies - Questionable effects on economic growth and development
Contrary to expectations, trade and market liberalisation may not lead to improved export performance and greater economic growth and development in some countries.
Countries that are better able to take advantage of opportunities offered by trade and market liberalisation are those that have already developed an industrial base, and are therefore better able to withstand the competition arising from the elimination or reduction of trade barriers. Low-income countries tend to perform the worst, because they can least withstand the competition with larger, more 'mature' foreign firms, and this sometimes leads to a weakening of their industry together with increased unemployment, poverty and growth of the urban informal sector.
Capital liberalisation, if undertaken before countries have developed the necessary institutions, may lead
to capital flight, reduced ability to conduct monetary policy in accordance with domestic priorities, and even financial crisis.
The withdrawal of government from provision of merit goods that often comes with market liberalisation has negative effects on economic and human development.
These processes have the effect of increasing inequalities between rich and poor countries, as well as between higher income and lower income groups within countries.
Definition of Interventionist policies
Interventionist policies are based on government intervention in markets intended to correct market deficiencies and create an environment in which markets can work more effectively.
Discuss the strengths of interventionist policies - summary
1. Correcting market failures
2. Investment in human capital
3. Provision of infrastructure
4. Provision of a stable macroeconomic environment
5. Provision of a social safety net
6. Redistributing income
7. Industrial policies
Discuss the strengths of interventionist policies - Correcting market failures
Governments have a major role to play in the correction of market failures. This includes policies that try to:
• correct negative environmental externalities of production and consumption and overuse of common access resources
• provide public goods as well as merit goods that are underprovided by the market due to positive consumption externalities - as we know this involves investments in human capital (health and education) and investments in infrastructure
• assist in the correction of co-ordination failures - government intervention is needed to help people escape underdevelopment traps by allowing the simultaneous occurrence of necessary activities
• contribute to the development of market institutions that enable markets to operate more effectively
Discuss the strengths of interventionist policies - investment in human capital
Investment in human capital (education and health) was noted above in connection with government policies to correct market failures. Education and health have significant external benefits, thus calling for government intervention (such as direct provision) that increases the consumption of both. Education and health are major factors behind increases in productivity that contribute to economic growth, and they also directly lead to greater economic and human development. Investment in human capital also forms a part of industrial policies, discussed below.
Discuss the strengths of interventionist policies - provision of infrastructure
The provision of infrastructure also forms part of policies to correct market failures (noted above). Infrastructure includes a broad range of goods and services, also with significant positive externalities. As a type of physical capital, it includes water supplies, sanitation and sewerage, power, communication, transportation, roads, irrigation, and many
others. All of these play a very important role in encouraging economic growth, as well as making possible economic and human development. They increase productivity, and make a direct contribution to improved standards of living. Therefore, there is a strong role for governments in order to ensure the provision of the appropriate kinds of infrastructure, with the appropriate access by the population.
Discuss the strengths of interventionist policies - provision of a stable macroeconomic enviroment
A stable macroeconomic environment includes price stability (the general price level should rise only gradually); full employment (people willing and able to work should be able to find a job); a reasonable budget deficit; and a reasonable balance of trade (avoidance
of large trade or current account deficits).
The market mechanism cannot accomplish these tasks on its own, and requires government intervention through the use of appropriate policies in pursuit of these objectives.
stable macroeconomic environment is important for ensuring that economic decision-makers (consumers, firms and resource owners) can plan their future economic activities (such as consumption investment, imports, exports, etc.). It is a key condition for investment, in particular, leading to the formation of physical and human capital, which are fundamental prerequisites for economic growth.
Discuss the strengths of interventionist policies - provision of a social safety net
The market cannot ensure that everyone in a society can secure enough income to satisfy basic needs (food, shelter, etc.).
The government must therefore step in with the provision of a social safety net to ensure that people falling below a minimum income level will be able to secure their basic needs.
A social safety net is a system of government transfers of cash or goods to vulnerable groups, undertaken to ensure that these groups do not fall below a socially acceptable minimum standard of living.
The provision of a social safety net by the government is very important in a market-based economy, where there are risks of becoming unemployed or falling into poverty.
Discuss the strengths of interventionist policies - redistributing income
Another method to deal with the market's inability to secure everyone a minimum income involves government's policy of income redistribution.
Discuss the strengths of interventionist policies - industrial policies
Industrial policies are interventionist supply-side policies that include support for small and medium- sized businesses as well as protection of infant industries (such as through tariffs or subsidies) in order to help developing countries in the early stages of their industrialisation.
In addition, industrial policies include government support of appropriate technology transfer from developed countries and the establishment of a research and development capability, as well as the investments in human capital.
Discuss the limitations of interventionist policies - summary
1. Excessive bureaucracy
2. Poor planning
Discuss the limitations of interventionist policies - Excessive bureaucracy
A bureaucracy is an administrative structure of an organisation involving rules that determine how
the organisation functions and carries out its tasks.
Governments often run into the problem of excessive bureaucracy, meaning there are too many rules governing procedures, red-tape, unproductive workers, high administrative costs and inefficiency.
This is a key argument often used in favour of reducing the size of the government sector through privatisation of government-owned enterprises, contracting-out of government activities, and private financing of public sector projects to reduce bureaucratic procedures and improve efficiency.
Discuss the limitations of interventionist policies - Poor planning
Government planning involves making decisions on what and how much of certain goods and services it will produce, how these will be produced (by use of what resources), how much they will cost and what revenues they might be expected to provide. Planning plays a major role in government provision of merit goods and public goods, as well as numerous government policies such as taxes, subsidies, transfer payments as well as virtually all of its economic activities.
Planning may run into difficulties because it requires technical knowledge and expertise on the part of planners, which they may not possess, as well as a tremendous amount of detailed information, much of which is often not available. The result is that planning can become highly bureaucratic and inefficient, resulting in a waste of resources.
Discuss the limitations of interventionist policies - Corruption
Corruption is often associated with lower growth
and poorer development prospects. When it takes the form of a payment for something, it works like a tax that makes private investments more costly, reducing the overall level of investment. If it involves bribes to receive basic services like education or health care it works like a regressive tax, because the bribe is a higher fraction of the income of lower income earners.
Unlike taxes paid to the government that become available for use in socially desirable activities, bribes go into the pockets of public servants and politicians, depriving society of resources that could have been used to pay for the provision of important merit goods.
Bribes for tax evasion result in further reducing government revenues.
Corruption can also result in a misallocation of resources as government officials accept bribes to pursue uneconomic projects (such as dams and power plants) instead of socially necessary services like education, health care, sanitation, etc.
Corruption can also weaken sustainable development as government officials may accept bribes to bypass environmental regulations. Finally, corruption damages the people's trust in the state and encourages contempt for the rule of law.
Explain the importance of good governance in the development process
Governance is not about what is done for economic growth and development, but rather how it is done.
It is about the effectiveness of government, but also
it involves the relations between government and society, and how they interact to make decisions.
Good governance is important because according to studies making cross-country comparisons, better governance is related to more investment and greater economic growth. The effectiveness of government, the efficiency of bureaucracy and rule of law are positively related to economic performance and adult literacy, and negatively related to infant mortality.
Discuss the view that economic development may best be achieved through a complementary approach, involving a balance of market-oriented policies and government intervention.
Neither the extreme of very strong government intervention, nor the extreme of a highly free market orientation, is appropriate for the conditions of developing countries, therefore there must be a mix of market-based and interventionist policies.
The broad conclusions make by supply side policies
1. Very strong government intervention in the market, such as that pursued during the 1950s and 1960s, has been mostly discredited as a strategy for economic growth and development, and international trade.
2. A market-led economic development strategy with a minimum amount of government intervention, such as is represented by the Washington Consensus, does not take into account the special set of circumstances faced by developing countries.
3. The New Development Consensus outlines a number of areas in which governments of developing countries should intervene in order to promote growth and development.
4. It would be a mistake to take a blanket (or uniform) approach to all developing (or any other) countries with regard to proposals for market-led or interventionist strategies (or any other type of strategies for that matter).
5. It is likely that countries at lower levels
of economic development can benefit from strategies that are more strongly interventionist; government can gradually withdraw and give greater reign to market forces as the country grows and develops.