Rationale for government intervention
There are six major functions the government can perform in an economy.
1. The government provides a legal and social framework within which market individuals and sellers buy and sell goods and services produced from the scarce resources of the economy. Laws are passed to define the legal status of business in terms of rights of private ownership, and enforcement laws, so as to ensure a fair and orderly relation between the producers and the consumers. These regulations include licensing, patents, restrictions on price competition, and restrictions on free flow of international trade.
Licensing is usually justified to ensure a minimum degree of competence and to protect the public against fraud and harm in cases where it is difficult for the public to gather information about the quality of product or service. It is often used to restrict entry into business, profession, or trade and to restrict competition. Patents restrict entry by providing the patent holder (individual or firm) to use the invention in exchange of royalty payments. Patent is the right granted by the government to an inventor for the exclusive use of the invention for a period of 17 years. Restrictions on price competition are in form of announcement of support prices, procurement prices, etc in agriculture, ocean shipping rates and many others.
2. Legislations are enacted to maintain competition in markets for specific goods and services. The Indian government passed the monopolies and restrictive trade practices act in 1969 to deal with anticompetitive or monopolistic behaviour.
3. Redistribution of income so as to achieve economic justice. This is achieved by government by several means such as progressive income tax and transfer payments in the form of subsidies and unemployment benefits.
4. To reallocate resources as misallocation of resources leads to externalities, that is, some benefits and costs. From the perspective of supply-and-demand analysis, the presence of cost externalities tends to increase the supply and lower the price of a product. Thus, the quantity of the product will generally be greater than it would be without this type of externality.
5. Stabilisation of the aggregate economy is the next objective of government intervention. The market economy is prone to periodic upswings and downswings. Downswings in the cycle are accompanied by reduction in output, jobs, and income, and upswings in the cycle are often accompanied by inflation. Government in India has used monetary and fiscal policy to control the volatility of business cycles.
6. Government plays an active and direct role in regulation of natural monopolies (firms in which the average cost of production falls continuously with an increase in output) like electricity and water supply, does not fall under any of the categories listed above. Government regulates certain key aspects, such as prices and the amount of profits, of "natural monopolies."
From above it follows that, in order to maximise national income in the long run, the government may employ either
- indirect methods like industrial, monetary, fiscal and commercial policy or regulations in the form of incentives and disincentives; or
- direct methods through provision of public goods.
Indirect controls comprise rules and provisions to regulate the private economic activity. Custom duties, taxes, subsidies, credit policy, monetary policy, etc. fall under this category. For example, manufacturers of cotton textile may be free to produce any type of textiles they like, but government may offer subsidies, credit and other facilities if the government aims at increasing output of coarse cloth badly required by the poor consumers. Similarly, the government may restrict manufacture of luxury automobiles (which it considers to be non-essential) by imposing heavy excise duty on them. Methods of indirect control are not as effective as direct controls. Measures of indirect control preserve the price mechanism and try to modify it. Direct controls involve physical controls relating to the prices and distribution of goods and services, like industrial licensing, quota restrictions, etc.