SUMMARY

SESSION 3: GOVERNMENT AND THE ECONOMY

Welcome to the third session of unit two. Individuals, businesses, and governments all have decisions to make regarding the use of resources. However, these resources are not available in abundance for their use. This creates a problem for all economic agents known as the economic problem.

Read Before: SESSION: 2

This session discusses the economic problem and the various ways government can tackle this problem. This session promises to be an interesting one, are you ready?

Then come with me.

Objectives By the end of this session you should be able to:

(a) explain the economic problem
(b) describe how various governments tackle the economic problem
(c) mention and explain the reasons for government intervention;
(d) explain the various government economic objectives

Now read on …

3.1 The Economic Problem

At the heart of the study of economics is the problem of how countries attempt to match the demands on their resources with the available supply. Despite phenomenal growth in production since the Industrial Revolution, there is no evidence that, even in the richest countries, people’s wants are not satisfied.

Although most people in the industrialized world are well-fed, clothed, and housed, new wants are continuously being created: stores continue to be crowded with people wanting the latest fashions and electronic gadgets.

Even the nature of the desirable home has changed. Indeed, in these countries there often remains a desperate need for the most basic of foodstuffs and other necessities of life to ward off malnutrition and disease.

The message is clear enough: wants are limitless, but the resources to satisfy them are scarce. Therefore, all societies-from the richest to the poorest- share a common economic problem involving the allocation of scarce resources to meet the needs and demands of consumers and producers.

How should resources be allocated when satisfying one set of wants inevitably means another set is not met?

This is equally true for individuals, firms, and governments, everybody faces the same kind of economic problem.

The individual who buys a larger house may have to forgo an annual foreign holiday or the purchase of a new car. The firm that pays more to its workforce may have to reduce its investment in new machinery.

When the government buys more school books out of the education budget, there may be a shortage of money available to employ teachers. In other words, every decision involving the satisfaction of wants using scarce resources involves a choice. Each use of resources means forgoing some other use.

When discussing resource use, economists use the term opportunity cost to describe the next best option or alternative forgone.

3.2 Government and the Economy

All societies face the economic problem outlined above but they may attempt to solve it in different ways. Generally, countries around the world approach the economic problem in either of the following approaches also known as economic systems; planned/command economy, free market economy/capitalism, or mixed economies. Let’s try and explain the three approaches. Do you know which of the approaches is applicable to Ghana?

3.2.1 Planned or Command Economy

Under this approach, a central planning body makes all of the decisions about what is produced, whose wants are met, and how. The former Soviet Union was a good example of a planned or command economy before its break up in the early 1990s. There, resource use was directed through a powerful hierarchy of state agencies headed by the USSR State Planning Committee (called Gosplan) along with the Ministry of Finance and around 900 ministries and departments scattered across the Soviet Union.

In principle, Gosplan controlled the entire national economy of that country. The planners decided what to produce, how the goods and services should be supplied, where production should take place, and to whom the goods and services should be distributed.

3.2.2 Free Market Economy or Capitalism

A free market economy is associated with the private ownership of resources and the profit motive – an economic system known as capitalism. Instead of the allocation of resources through central planning, a capitalist economy uses prices as a signal to both producers and consumers exchanging goods and services in the free market.

Prices indicate what and how much firms should produce to maximize their profits and they regulate how much consumers will buy to satisfy their wants. In this way, the price mechanism allocates resources according to consumer demand reflected in the prices that consumers are willing and able to pay.

A major objection to capitalism, however, is unfairness in the distribution of resources, and it is this which led to the rise of socialism as a political and economic alternative to capitalism in the nineteenth century – socialism is associated with a planned economy.

3.2.3 Mixed Economy

In practice, all economies fall somewhere between the two extremes of central planning and completely free, capitalist markets. They are known, therefore, as mixed economies. In the former Soviet Union, while most resources were allocated by the state, there still remained a small market sector.

In contrast, in the USA (generally recognized as the leading capitalist economy), there is considerable state involvement in the provision of welfare services, law and order, and defense. The extent to which this should and can be done without creating economic disincentives remains controversial.

3.3 Government Intervention

There are many reasons why governments may want to intervene in markets, and even in capitalist economies. These come under a number of headings that would be described below. In your view, why would government intervention be necessary? Let us now look at some of the reasons why a government would intervene in an economy.

3.3.1 Provision of Essential Services

Governments may provide certain services such as health, education, policing, sanitation, etc. for everyone regardless of their ability to pay. Such services are sometimes referred to as merit goods, in the sense that governments may regard it as meritorious or morally right to secure equality of access to such goods and services for every citizen.

3.3.2 Transfer Payments

Transfer payments are payments by the state for which no goods or services have been offered in return and are intended (usually) as a means of maintaining living standards for those in society who are in most need.

They are paid out of taxation receipts. Examples of transfer payments include unemployment benefits and pensions for retired workers provided by the state. A typical example of a transfer payment is Livelihood Empowerment against Poverty (LEAP) and School Feeding Program.

3.3.3 Natural Monopolies

Generally, economists believe that free-market competition is beneficial because it provides consumers with the maximum choice of suppliers and provides maximum incentives for firms to produce efficiently.

However, governments may decide to intervene directly in certain sectors of the economy where, for technical reasons, competition cannot occur.

For example, governments are likely to intervene where there are large investments in distribution systems so that it is prohibitively expensive to lay down more than one system, such as in parts of the gas, water, and electricity sectors (the so-called public utilities). These are commonly referred to as natural monopolies.

In many countries after World War II such natural monopolies were state-owned: governments felt that private ownership of natural monopolies was socially and economically unacceptable.

Today, however, many countries have privatized or are in the process of privatizing their gas, water, and electricity industries. This diminishes the role of the state but does not remove it altogether.

The newly privatized public utilities normally remain state-regulated in terms of their pricing policies and service levels.

3.3.4 Social Costs and Benefits

Governments intervene to control or prohibit certain goods and services which are considered to have a detrimental effect on society, for example, drugs and pornography. In addition, governments may also intervene to protect society from the side effects of others’ actions, for instance, the control of pollution and the prosecution of polluters. Such side effects (or spillover effects) are called social costs or external costs.

Equally, governments often promote the supply of goods and services which are considered to have appreciable social or external benefits, for example, the provision of free inoculations against infectious diseases.

Government intervention with regard to control of these externalities may take many forms including laws and regulations, fines and compensation payments, as well as taxes and subsidies aimed at reducing or encouraging supply.

Goods and services with appreciable externalities and where it is difficult or impossible to exclude non-payers from their consumption, and where consumption by one person does not restrict consumption by another (e.g. defense services), are usually referred to by economists as public goods.

3.3.5 Support for Industry and Commerce

Just as governments provide support for individuals so they may also choose to support individual firms or entire industries.

This may take the form of industrial and regional aid – notably grants, subsidies, tax concessions, and planning exemptions. Governments support firms for a variety of reasons – social and political as well as economic.

The economic reasons include a desire to increase investment, finance risky research and development, redistribute employment, increase total employment, and benefit exports.

3.3.6 Management of Total Demand in the Economy

Government may intervene to control and stimulate the level of total (i.e. aggregate or national) economic activity.

This is based on the view that, left to its own devices, the free market does not necessarily lead to full employment of the nation’s scarce resources and therefore operation on its optimum or highest potential production possibility curve.

Equally, the free market might lead to high and unacceptable inflation. Government intervention for much of the second half of the twentieth century in many Western nations was directed mainly at regulating the level of total demand in the economy to influence employment and prices.

More recently, attention has switched towards stimulating the economic supply of goods and services in the private sector (supply-side economics) and away from demand management. Whether governments should aim to control demand, especially through changes in taxation and public spending, is a subject that has attracted considerable debate amongst economists and policymakers – and is one which we explore throughout this course.

3.4 Government Economic Objectives

Governments have a number of economic objectives, although the importance of each and the trade-offs between them vary from time to time.

Several of these have been mentioned already and some of the most common include a high and sustained level of economic growth, full employment of economic resources, including labor, low and stable inflation, and a sound balance of payments coupled with a stable currency value in the foreign exchange markets.

The pursuance of these objectives is made all the more difficult by the existence of policy conflicts or what are often called policy trade-offs.

Trade-offs may arise, such as between having a lower rate of inflation and a higher rate of employment, in the policy measures adopted by the government. These policy conflicts will be dealt with further in subsequent sessions.

3.5 Policy Targets

Targets may be defined as quantifiable aims set out by governments and which governments (and other official bodies, in particular, central banks) attempt to achieve using policy instruments. Examples of policy targets might be economic growth in real terms (allowing for inflation) of say 3 percent per annum; reduction of unemployment by 250,000 per annum; restriction of inflation to no more than 2 percent per annum, and so on.

3.6 Policy Instruments

Once the policy targets are set, governments may choose from a range of policy instruments in their efforts to achieve them. Instruments may include, for example, changes in the level and structure of interest rates, credit restrictions and other monetary controls, exchange controls, and changes in taxation.

3.7 Policy Goals

A policy goal is what the government is ultimately attempting to achieve, for example, stable prices over time, full employment, or strong and sustainable economic growth. This distinction between policy targets, instruments, and goals features in later lectures.

In this session, we found out that human wants have always exceeded the available resources to satisfy these wants leading to the economic problem.

Governments try to solve this economic problem using a number of ways either through the economic system or through government intervention. Government objectives or goals are achieved through policy targets and instruments.

Self-Assessment Questions

Exercise 1.3

Outline any five reasons why governments will intervene in an economy
Explain the economic problem
Compare and contrast the following
free market economy
command economy and
mixed economy
Explain the following
policy goals
policy targets
policy instruments.
What role can government play in the macro economy?

SESSION: 2

CONTINUE WITH SESSION: 4

GOVERNMENT AND THE ECONOMY