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Sunday, August 2, 2015

Role of The Government In The Economy : A Detailed Explanation (WBCHSE Economics Syllabus,Class XI)

Before plunging into the content of this chapter,let me say what I like the best about Economics. I love the subject so much because of the culmination it is of numerous topics (most of which are my personal favourites)! It contains in itself a splendid amount of Maths,Statistics,Political Science,History,Social Relations,International Relations,Human Relations,Psychology,Science,Geography and I still have a long way to go before I figure out what more lies inside.Moreover,it involves freethinking more than anything else and if you think Economics is Biology,you have absolutely no place here.Either you will have to have Mathematical skills,thinking ability,analytical ability and a solid command over English (because most books on Economics are written in English) or it is just impossible to study Economics.You cannot get over in exams of any sorts by memorising points because you will simply remember nothing that way unless you have an eidetic memory!
I felt quite encouraged to do this post after receiving my first test paper on Economics in 
Class XI and watching the 650+ reads I had on my post on UPSC Maths Questions (Day 23) in this week!
I picked this chapter because I could complete this in a short while and I honestly do not have a long time.The content is much less compared to all the chapters up to Chapter 5. And about Chapter 5,all I can say is this is the first time I am taking such an intense interest in Macroeconomics.(I have been loving Microeconomics ever since I have known about it.)
So,to start with,there are 3 basic problems in an economy : -

  • What to produce and how much to produce.
  • How to produce.
  • For whom to produce.

Many are opinionated that only in a market economy,full utilisation of resources is possible.This view,however,is not true.Even in a market (or capitalist) economy,government does have a role to play.After all,what is the use of optimum allocation of resources in an economy if we cannot achieve the tiniest bit of equity in the economy?Will that give the economy any stability,the people peace or the environment a chance to huff a sigh?

(Please keep in mind that the socialist system is considered superior to the capitalist system according to Economics.Of course The Perspectives will not serve ideological propagation in terms of study related material,unlike the super opinionated Khan Academy.That guy who teaches Political Science there should not at least forget that he is being a teacher and not some anti-socialist freak trying to drive students the way he wishes to.Here,you do not necessarily need to be of any colour,I would just do my best letting you know what the subject says.)

So,the question is,why is the view not correct that there should be absolutely no government interference or intervention (or existence of a Laissez-faire system) in a society?

Here,we have to learn that there are 3 main functions of the government in the market economy : - 

  • To secure adjustment in the allocation of resources.
  • To secure adjustment in the distribution of income and wealth.
  • To secure economic stabilisation.
In a free enterprise economy,optimum allocation of resources is contingent upon the fulfillment of certain conditions such as existence of perfect competition,absence of external effects in production and consumption etc.These conditions are not always fulfilled and hence the market system fails to make optimum allocation of resources in some situations.These are known as situations of market failure.In such situations of market failure,the government must interfere on economic activities to ensure optimum allocation of resources.

The Different Conditions Under Which Market Failures Might Occur

  • In case of a monopolistic market,where there is only one firm in the industry and one seller in the market,price will be higher than in the perfectly competitive market and productivity will be lower than that in the perfectly competitive market.Hence,in such a situation market failure will take place.
  • Secondly,when there is requirement of a huge amount of investment,due to indivisibility of capital,it is not possible to produce in a small scale.Private entrepreneurs do not come forward in such conditions and there is a market failure.
  • There are some commodities which are jointly consumed by all consumers once they are provided.Such commodities are called social goods.Examples of such social goods are maintenance of law and order,defence,judiciary etc.Private entrepreneurs are not willing to provide these goods (since their main intention is always profit).
  • To prevent overutilisation of common property resources.
  • Fifthly,to protect the interests of buyers and sellers,government regulation may be needed in some situations.For example,when there is a shortage in foodgrains,private owners start charging a very high cost price for foodgrains (why?*1) and as a result the poor buyers suffer.In such a case,government might have to step in to protect people's interests.
  • When there are external effects in production,there is divergence between private costs and social costs of production.Since private owners are concerned with private gain and not social gain,they will consider only the private costs and not the social costs.In such a situation,to prevent market failure and for that to happen,to maximise social costs or social gain,government interventions are necessary.
Example 1. Suppose that the price of jute falls in an year if the price is set by the
demand-supply mechanism. (That is,there is more supply than demand in the market.)So,what will happen is the jute growing farmers will suffer a severe loss. To curb this situation,the government might decide the floor price to be higher than the price set by the demand supply mechanism.This will help in limiting the misery of the (generally poor*2) farmers.
Photograph has been thoroughly edited from its original form for better understanding.

The above graph has been shown to give you an idea of how this works.For example,consider that the price of jute achieved by the interaction of demand and supply to be P0. Now,the government might set the floor price P1 instead of P0 to aid the economic betterment of the farmers.
Now,consider another situation in which the price goes up and results in suffering of the poor people,for example the rise of price in foodgrains during a food shortage crisis or famine in a country.Then,the government might have to step in and help the economically downtrodden people of the country by minimising the price,which can be explained by the help of the graph given below.

Photograph has been thoroughly edited from its original form for better understanding.

Here,if we consider the price attained through the automatic interaction between demand and supply,the price would have been P0. Due to government intervention into the system,the price has been fixed at P1,which is clearly lower than P0.

Similarly,to increase the production of a particular commodity,a subsidy may be granted for the production of that particular commodity.Or to decrease the production of a particular commodity,sales tax may be levied upon it.This will naturally increase the cost of the product and as a result,the demand in the market of that particular commodity will be subsequently reduced.
Private Goods And Public Goods

The goods produced in any country may be of two types.Either they are produced by provate owners and then sold in the market or they are indivisible goods which are enjoyed equally (by convention) by the common people.Examples of private goods includes a vast array of commodities that are produced by private individuals whereas public goods include defence,law and order,public administration etc.
The differences between public goods and private goods have been discussed below :-

Public Goods
                                  Private Goods
 Production takes place in public sector.
Production takes place in private sector. 
 Public goods are indivisible.
 Private goods are divisible.
 Exclusion principle is not applicable.
 Exclusion principle is applicable.

In case of public goods,preferences are not revealed in this manner.

 In case of private goods,an individual is willing to pay higher or lower prices according to his preferences.

 Market is not required for utilisation of public goods.
Market is required for demand and supply to operate in case of determining the prices for private goods.

Private Investment And Public Investment

The investment expenditure made by an individual or a private firm is known as private investment expenditure.
Social investment refers to investment expenditure incurred by the government.
Can you think of an example of the two distinguished kinds of investments?

Pollution Tax

 Pollution tax (or Ecotax) refers to taxes intended to promote environmentally friendly activities via economic incentives. Such a policy can complement or avert the need for regulatory (command and control) approaches. Often, an ecotax policy proposal may attempt to maintain overall tax revenue by proportionately reducing other taxes (e.g. taxes on human labor and renewable resources); such proposals are known as a green tax shift towards ecological taxation. Ecotaxes address the failure of free markets to consider environmental impacts.
Ecotaxes are examples of Pigouvian taxes, which are taxes that attempt to make the private parties involved feel the social burden of their actions. 

Redistribution of Income

Let us talk a little casually here.I think it is best to talk about Trickle Down theory (which of course,does not work in achieving equity of any kind) here if we are talking in the modern context but in general,what works in a capitalist economy except ownership? Private ownership,to be specific.Now,what happens (If I start explaining why it happens or how it happens,we will never get through the contents of this chapter.) is the inequality of income often increases to an extent where disparity in income begins to sow the seeds of class struggle.To avoid this disparity in the first place,government interference is necessary.
Next,how does the government do this?
The government might imply tax-transfer policies for this reason.The income tax,wealth tax etc. collected from the rich can be distributed among the poor as transfer payments such as unemployment allowances,gratuitious relief,old age pensions,widow pensions etc.In this way by taxing the rich and by providing transfer payments to the poor,the government can try to redistribute income.This policy is known as tax-transfer policy.

Progressive,Proportional And Regressive Tax 

Suppose ₹22,000 is exempted as income tax from an individual who earns ₹50,000 per month.Then,the taxable income of the individual will be ₹(50,000 - 22,000) = ₹ 28,000.
Now,if it is found that the income tax liability of an individual increases at the same rate in which his taxable income increases,then this system of taxation is known as proportional income taxation.If the tax liability and the taxable income grow at the same rate,then the ratio of tax liability to taxable income will remain the same.
If T denotes the total tax liability and Y denotes the taxable income,then T/Y is called the average rate of income tax.
The tax system is said to be progressive when the rate of increase in tax liability is greater than the rate of increase in taxable income.Here,as the taxable income increases,the average rate of tax also increases.
The regressive tax system is just the opposite of the progressive tax system.Here,as the taxable income increases,the average rate of tax also decreases.This means that a higher rate is applicable to lower income and a lower rate is applicable to higher income.

Arguments For And Against Progressive Tax System


  • The progressive tax system can be supported keeping in mind the ability to pay principle.The rich people have a lower marginal utility of income and a higher ability to pay taxes.Under a progressive tax system,a higher rate is applicable to them.In the same way,lower rates of tax are exempted on the income of the poor,who have a lower ability to pay taxes.
  • According to John A. Hobson,there are two parts in the income earned by an individual.One part is the cost element and the other part is surplus.If tax is levied on the cost element,the incentives to work is adversely affected.Hence,tax should be imposed on the surplus component.As the rate of income increases,surplus also increases.So,the tax should also be increased which is possible under Progressive Tax System.
  • Thirdly,the progressive tax system can be used to eliminate inequality in the distribution of income and wealth.By imposing higher rates of tax on the rich and subsequently implementing tax-transfer policies to redistribute this amount among the poor,economic inequality can be significantly reduced.
  • According to Arthur Cecil Pigou,least aggregate sacrifice by the people is possible under the progressive tax system.Since the marginal utility of the income to the rich is very low,the sacrifice made by them in utility terms is also the lowest.Hence,least aggregate sacrifice is possible by implementing progressive tax system.
  • Very interestingly,the progressive tax system can be used to to control cyclical fluctuations in the level of income.It is possible to increase the total consumption of the economy by taxing the rich and redistributing tax revenue among the poor.It is possible to increase total consumption because the marginal propensity to consume of the poor is higher than that of the rich.
  • The progressive tax system can also be supported on the basis of productivity.This tax system is productive because it is possible to increase total tax revenue by imposing progressive taxes.

  • Rich people do not like progressive taxation.As a result,they try to submit false returns for their income and wealth and in this way try to evade taxes.
  • The high rates of tax charged under progressive taxation can adversely affect an individual's incentives to work.Since higher income here implies higher rates of taxes,people do not like to earn more because they will not be able to enjoy most of the extra income.
  • The progressive tax system hinders the process of capital formation (savings).Since a part of income will be saved and invested,capital formation requires increase in saving but if people do not like to earn more income,then the propensity to save will also be lower.
  • Under the system of progressive taxation,the computation of tax liability becomes complicated.Since different rates of tax will be applicable for different levels of income,the tax liability cannot be calculated easily.
  • Under the system of progressive taxation,the average rate of tax increases with the increase in taxable income.But there is no universally acceptable rule that determines the relation between the increase in the taxable income and the rate of tax charged on it.

Natural Monopoly

By monopoly,we mean a market situation where there is a single seller selling an output which has no close substitutes to a large number of buyers.Only one firm produces the product.No other firms produce the same product.
If a monopolist firm is such that its average cost (or cost per unit of output) falls continuously as the output level increases,this monopoly is known as natural monopoly.Generally,such natural monopoly is present in public utility services.Public utility services are those services and goods which are essential for leading a basic,healthy life such as electricity,water supply,telephone,communication,transportation etc.

Four features of public utility services can be enlisted here :-

  • Public utility services are essential for the individual.
  • These services should be provided periodically.
  • Large amount of capital is invested for providing these services.
  • Firms providing such services enjoy monopoly position.
The three notable features of natural monopoly can be enlisted as :-

  • The proportion of fixed cost in total cost is very high in case of natural monopoly.
  • Since average cost decreases,the marginal cost is less than the average cost.This means that cost of producing one additional unit of output is less than the cost per unit of output on an average.
  • Thirdly,to set up such an organisation which will be a natural monopoly,large amount of money will have to be invested initially in fixed assets.
Natural monopoly can be controlled in two ways :-

  • The government may be the owner of the concern.A government-owned firm ensures that these services are supplied to the public only for the public interest even in the case the government is suffering losses in.
  • The government can permit a private firm to operate as a monopolist through legal enactment and at the same time impose certain restrictions on the monopolist through provisions of this Act.This restriction is specifically related to pricing by the monopolist.

If you have any questions regarding this chapter or the content explained above or if you figure out flaws in the explanation provided,feel free to comment or contact me via the form embedded before the attribution (Copyright declaration) of this page.

Book/Knowledge Material Credit : 'Higher Secondary Economics Class XI by Jaydeb Sarkhel' Printed by Orient Blackswan on behalf of West Bengal Council of Higher Secondary Education (WBCHSE).

*1 - When supply is limited and demands are excessively high,prices of that certain commodity will automatically rise in a capitalist/market economy.
*2 - This is due to the trickle down theory that often operates in most capitalist/mixed economies and creates a highly undesired wealth distribution structure.

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