Economic Rationale for Government

Mercantilism is crucial in modern economic thinking because of its influence on Adam Smith. Mercantilism was an economic system of trade dominant in Europe (originally in France) from the 16th18th centuries. It was based on the principle that the best way to increase national wealth was to maximize exports and minimize imports. Governments used protectionist import tariffs and subsidies to build wealthy and powerful states.

This French term implies “allow to do/leave alone” and was coined by Physiocrats. Physiocracy was a school of economic thought that emerged in 18th-century France.

The Physiocrats, led by François Quesnay, asserted that governments should not impose policies that interfere with the operation of natural economic laws, and the origin of wealth should be sourced from the land. Quesnay indicated the main principles of laissez-faire economics as follows: “That there be maintained the complete freedom of commerce; for the policy of interior and exterior commerce the most sure, the most exact, the most profitable to the nation and the state, consists in the full freedom of competition

The Great Depression was the beginning of a new era. The great economic turmoil between 1929 and 1939 was the worst economic downturn in the history of the US and the modern industrial world (especially Europe). It began with the stock market crash in 1929 in the US and rapidly developed and
spread to the rest of the world. By 1933, real GDP had fallen by 29%; the unemployment rate had reached a peak of 25%; consumer prices had fallen by 25%; wholesale prices had plummeted by 32%; and nearly a third of banks had failed in the US.

President Franklin D. Roosevelt introduced a set of policies between 1933 and 1939 to combat the Great Depression. The Roosevelt administration announced new acts and regulations—known as the New Deal— to provide economic relief and to create jobs. The role and size of the federal government were
expanded owing to the increasing number of public projects, regulations and financial reforms.

In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money as a challenge to the orthodoxy. His approach became the standard macroeconomic model for many years. Similar to Roosevelt, Keynes assigned a major role to the public sector, aiming to increase aggregate demand and employment opportunities. “According to Keynesian economics, state intervention is necessary to moderate the booms and busts in economic activity, otherwise known as the business cycle…. because prices are somewhat rigid, fluctuations in any component of spending…. cause output to change” 

The Phillips curve shows an inverse relationship between the unemployment rate and the rate of inflation.

Keynesian approach lost its influence owing to stagflation in the 1970s. Stagflation was a brand-new phenomenon wherein both inflation and unemployment rates were high. This fact indicated that the traditional Philips curve, which proposed a trade-off between unemployment and inflation, was no longer valid.

New classical economics became the mainstream theory in response to the failure of Keynesian economics (Fair, 2018). Classical economists believe that government intervention is not necessary for adjusting business cycles, and markets clear quickly through adjusting prices and wages. Thus, the free-market economy is the only way to allocate resources optimally. Policies such as globalization, austerity, privatization and deregulation were introduced and reintroduced in this era of neoliberalism. Neoliberalism’s policy pillars were generally accepted until the Great Recession.

The 2008 financial crisis—or the Great Recession—was the most critical shock to the world economy since the Great Depression of the 1930s (Chen et al., 2019). The deregulation of financial derivatives was considered the primary cause of the crisis. Owing to the bursting of the housing bubble, the sharp fall in asset values led to aggregate losses of $50 trillion in 2008 (Drezner and McNamara, 2013), and the US unemployment rate reached 9.5% in 2009. The shock spread to the rest of the world, and European economies fell into debt and banking crises. Concerns about government intervention lost their potency owing to the severe economic conditions experienced during the Great Recession. In contrast to the neoliberal discourse, many countries put regulations and public goods/services back on the agenda for economic recovery and growth.

This view originated in ancient Greece with Plato, who focused on the relationship between the state and the individual. The organic approach is an ideological framework for both authoritarian and paternalistic states. The individual who finds this view attractive would agree with John F. Kennedy, who said “Ask not what your country can do for you, ask what you can do for your country.” Thus, each individual contributes to the public good.

In this view, the state is considered to serve individual interests. This approach is closely linked to the liberal approach. In Herbert Spencer’s words, “…the welfares of citizens cannot rightly be sacrificed to some supposed benefit of the State, and why, on the other hand, the State is to be maintained solely for the benefit of citizens. The corporate life must here be subservient to the lives of the parts, instead of the lives of the parts being subservient to the corporate life” (1891: 276–277). In other words, the individual good precedes the public good.

Pure public goods have two critical properties. First, the additional cost is zero for another person who enjoys the good. Second, preventing individuals from enjoying the good is difficult or impossible.

Vito Tanzi (2020) highlighted the difference between the normative and positive roles of the government. The government determines policies to be adopted in the context of its normative role. However, implementation of these policies may be difficult. Here, Tanzi warned us that there might be “termites” in government operations that are “digging holes” between the normative and actual policies.

Musgrave (1989) suggested that the government have three branches: allocation, distribution and
stabilization.

The allocation function covers the provision of social and public goods, which are described as both nonexclusive and non-rivalrous. As efficiency rules are different for public and private goods, the standard approach, designed for private goods, is not valid for public goods. For private goods, the marginal cost equals the marginal utility for each consumer. However, this is not the case for public goods. For public goods, the marginal cost equals the sum of the marginal utilities derived from all consumers. Therefore, the market mechanism does not apply to public goods. The government’s provision of public goods through taxation is considered a way to overcome this problem.

The distribution function is closely related to the allocation branch. The relationship between the efficiency frontier and the hypothetical social welfare function implies an optimal provision point for social goods. This point indicates a specific welfare distribution pattern. Thus, the decision on what is to be produced (allocation function) is simultaneously determined by the distribution problem. However, public services, which are provided through the allocation branch, are determinants of the relative prices of private goods and earnings. Additionally, gains (as a result of the provision) are included in the final welfare distribution pattern. Hence, discussing the simultaneous determination of the distribution and allocation branches is impossible. These two views make the analysis of the distribution function more difficult.

The stabilization function is based on the control of aggregate demand in an economy through transfers and taxes. In the mid-1960s, the major macroeconomic problems were securing high employment and avoiding inflation. However, over time, new economic policies have been designed to maintain stability (high employment without inflation) as well as achieve economic growth. Although the role of budget policy has changed, it remains significant in macroeconomic policy.

Positive economics looks for “what is done” and focuses on how an economy functions. The most commonly used instruments for positive research are experiments and observations. 

Smith (1994) mentioned that seven significant reasons exist in the literature to explain why economists conduct experiments:
• To test a theory or discriminate between theories.
• To explore the causes of a theory’s failure.
• To establish empirical regularities as the basis for a new theory.
• To compare environments.
• To compare institutions.
• To evaluate policy proposals.
• To use the laboratory as a testing ground for institutional design.

Loewenstein (1999: F26) defined internal and external validity as follows: “Internal validity refers to the ability to draw confident causal conclusions from one’s research. External validity refers to the ability
to generalize from the research context to the settings that the research is intended to approximate.”

The main tool of econometrics is the linear multiple regression model, which provides a formal approach to estimating how a change in one economic variable, the explanatory variable, affects the variable being explained, the dependent variable - taking into account the impact of all the other determinants of the dependent variable

Normative economics deals with the question of “what should be done” and investigates the desirability
of alternative situations. Welfare economics focuses on the social desirability of alternative economic
states (Rosen and Gayer, 2010). It is a discipline that offers a toolbox for examining normative issues.
Thus, an economist can answer basic normative questions regarding economic organization (Stiglitz and
Rosengard, 2015: 63):

• What should be produced?
• How should it be produced?
• For whom?
• Who should make these decisions?

Welfare economics has two fundamental theorems: According to the first fundamental theorem, under
certain conditions, competitive markets guarantee Pareto efficient allocation of resources. The first theorem justifies Adam Smith’s famous “invisible hand.” The second fundamental theorem of welfare economics states that every Pareto efficient resource allocation can be achieved via competitive markets, with the appropriate initial redistributions.

An indifference curve is a graphical representation of various combinations of two goods that provide the same level of satisfaction to the consumer.

Marginal rate of substitution is the rate at which a consumer is ready to exchange a number of units of good 1 for one more of good 2 at the same level of utility.

Marginal rate of technical substitution is the rate at which one input factor can be substituted for another while retaining the same level of productivity.

Marginal rate of transformation is the rate at which one good must be given up to obtain an additional unit of another good.

To achieve total economic efficiency, three conditions must be satisfied (DesJardins, 2002; Stiglitz and
Rosengard, 2015):
• Exchange efficiency: Efficiency in the way goods and services are exchanged. The MRS must be
equal for all individuals.
• Production efficiency: Efficiency in the way goods and services are produced. The MRTS must be
equal for all firms.
• Product mix efficiency: “The optimal combinations of goods should be produced given the existing
production technology and consumer tastes” (Barr, 1998: 71). Hence, the MRT must be equal to
the MRS.

• Each person’s welfare depends only on the goods that they consume, and each firm’s profits depend
only on its own use of production factors.
• There are established and enforceable property rights over every good.
• There is a market for every good.
• Firms behave competitively and, in particular, believe that their own actions have no appreciable
effect on market prices.
• Participation in markets is costless.
• All market participants have the same information about the nature of goods and the circumstances
under which they are traded.

If one or more of these assumptions is not met, or is only partially met, the first fundamental theorem
of welfare economics is no longer valid. The market mechanism does not guarantee Pareto efficient
allocation of resources. When allocations achieved with markets are inefficient, market failure is said to
occur (Ledyard, 1989). According to Stiglitz and Rosengard (2015), markets fail and do not produce
Pareto efficient outcomes under certain conditions.

Because of

*Failure of competition: Although perfect competition is considered a necessary condition for Pareto optimality, competition is rarely perfect in the real world. Some firms have market power and can therefore raise prices substantially above cost or offer low quality (Tirole, 2015). For example, a monopoly occurs when a market consists of only one seller, and market entry is not possible. In this case, the firm is not a price-taker. A similar market structure is an oligopoly. In an oligopoly, a few firms dominate the market and have the opportunity to cooperate to maximize their profits. When imperfect competition emerges in a market, consumer exploitation becomes visible. The state is the only actor able to prevent monopolistic and/or oligopolistic exploitation to protect its citizens. 

*Public goods: Public goods are not produced (or are produced in insufficient amounts) by private markets owing to the free rider problem. Excluding non-payers from using public goods and services is impossible (or costly) because of their characteristics. Therefore, many users would not pay for goods and services, and a private firm would not have enough payers to recover the production costs (Ulbrich, 2011). The suboptimal provision of public goods as a market failure is inevitable because the private sector faces difficulties in the provision of public goods. As pure public goods such as peacekeeping, the rule of law, and environmental quality are crucial for human well-being, this lack of provision is a significant problem for society, and government intervention is recommended to solve the problem of the provision of public goods.

*Externalities: When production or consumption of a good or service by one agent creates external effects on the welfare of other individuals not reflected in the market price, government intervention may be needed to internalize these externalities. Externalities can be either negative or positive. For instance, if a company pollutes the air, individuals living in the neighborhood suffer. If no penalty is imposed, the company will continue to pollute the environment. An example of positive externality is the COVID-19 vaccine. If an individual is vaccinated, this leads to benefits for other members of society and eventually herd immunity. The government can impose taxes (or subsidies) to prevent (or encourage) actions or behaviors that have negative (or positive) effects on other agents.

*Incomplete Markets: In contrast to assumptions about complete markets, not all economic activities occur in a single period. Therefore, when time and uncertainty enter the picture, assuming that a market and associated price for each good exist is no longer reasonable (Magill and Shafer, 1991). The primary cause of market incompleteness is a lack of assets. Although there are some claims (such as insurance policies, futures, and options), the set of claims is always smaller than the set of possible outcomes, and the financial and insurance markets remain incomplete (Eyraud-Loisel, 2019). In this uncertain environment, government intervention can yield welfare benefits for society

*Information Failures: When information is distributed asymmetrically among agents, private markets cannot allocate resources efficiently. An example of asymmetric information is a deal between a buyer and a seller. The seller knows the full product specifications; however, this is not the case for the buyer. Therefore, the seller can take advantage of the buyer owing to the lack of information. According to Akerlof (1970: 488), “there tends to be a reduction in the average quality of goods and the size of the market. It should also be perceived that in these markets, social and private returns differ, and therefore, in some cases, governmental intervention may increase the welfare of all parties.” 

*Unemployment, Inflation, and Disequilibrium: The most well-known symptoms of market failure are high levels of unemployment and inflation. These issues and the role of the government in dealing with them are mainly discussed in macroeconomic theory.