The important thing for government is not to do things which individuals are doing already, and to do them a little better or a little worse; but to do those things which at present are not done at all. ~ John Maynard Keynes
A big bone of political contention across the globe is about the extent to which governments can intervene in the markets.
We have extremes of maximalist states like erstwhile USSR and current-day China on one side. We can pin the western democracies notably US and European countries on the other side.
India veered towards the maximalist state until 1991. Starting with economic reforms initiated in 1991, we moved towards limiting the government’s heavy-handed role in the economy. However, every now and then, people urge the government to play a more interventionist role in the markets.
This calls for a deeper analysis of the grounds where state intervention is legitimate. Particularly because, unlike the private players, the government has the authority to “coerce” people and institutions into submission.
Ajay Shah and Vijay Kelkar, in “In Service of the Republic“, aim to discuss this very point among many others. This is an exceptionally well-written book, valuable to public policy students and accessible to the general audience.
The book argues for economic freedom to be the default that society must adopt; where people pursue their self-interests freely. It reposes immense faith on the self-correcting nature of free markets.
However, the book observes that the state does have a legitimate ground to intervene in the event of “market failures“.
Market failures: They are situations “where the free market fails to deliver efficient economic outcomes“.
According to the book, market failures are of four types:
1. Externalities
Wikipedia defines it as “an indirect cost or benefit to an uninvolved third party that arises as an effect of another party’s (or parties’) activity.”
A factory that emits pollution in the neighborhood is an example of negative externality. The nearby residents must now bear the consequences of the pollution. When the news of a new metro line to an area results in spiking of property prices in the vicinity, that’s positive externality in action.
The point to note is the people bearing the brunt don’t have the power to influence the organization. Therefore, the self-correcting nature of market forces fails to work here. A factory, to continue the above example, has no incentive to act in residents’ interests.
Therefore, under such circumstances, the government has no option but to intervene.
2. Asymmetric Information
This is a situation where one party has more or better information than the other, and uses it to their advantage.
A classic example is medicines you buy at a shop. As a common person, you have no means to ascertain if the medicines are unadulterated. The ecosystem, by itself, has no incentive to upset the status-quo if it works to their benefit.
The 2007-2008 subprime mortgage crisis is an extreme outcome of asymmetric information. As this Bloomberg article says about the crisis: “..the more opaque the product, the more willing the credit rating agencies were to sign off on it. As for reputations, these often simply added to the crisis — people were probably too willing to enter into contracts with risky banks like Lehman Brothers and Bear Stearns, precisely because of these companies’ sterling reputations.”
Where the contract between two parties is based on unfair informational advantage, the government must step in to level the playing field.
3. Market Power
In competitive markets, companies need to balance a great product with the right price. Else, there is always an opportunity for a competitor to win the customers through better product/price.
However, when a company achieves a monopoly in a market, no such checks exist. They can increase the price (or reduce quality or output) without the fear of competitive reprisal.
In recent times, Google has been at loggerheads with various regulatory bodies on the charges of misusing their search monopoly to their advantage.
Left to themselves, the monopolies can use their market dominance to stall competition. Under such imperfect competitive environment, governments might be called upon to intervene.
4. Public Goods
No profit-oriented enterprise would invest on clear air, public safety, national security, infrastructure etc. by themselves.
Why is this?
Because these enterprises cannot hope to ask people to pay for providing, say, clean air. Further, they cannot restrict people not paying from using the clear air. So, a public good is non-rival and non-excludable. Non-rivalry means that when a good is consumed by a person, it doesn’t diminish the amount available to others. A good is non-excludable if it’s impossible to exclude some people from using it. If you now relook at clean air, it’s indeed both non-rival and non-excludable.
Conclusion
The book exhorts people to be careful about pressing for state intervention. Because rushing for state intervention in unwarranted situations, far from resolving the issue, may further aggravate the problem.
I conclude with the following appeal from the book:
When faced with a proposed state intervention, our first question should be:
“What is the market failure that this seeks to address? When market failure is not present, we should be sceptical about state intervention. This is a valuable way of drawing the line between central planning and legitimate intervention in the economy.”
Musings by Madhav 
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