Development Dynamics - UPSC PDF Download

The Role of Market and State in Development

• A market is an organization that facilitates voluntary transactions between producers and consumers of goods and services. It can range from simple interactions, like a vegetable bazaar, to more complex systems where supply and demand go through various stages of transportation and storage. In a free market, transactions are voluntary and based on the free will of buyers and sellers. For a market to be perfectly competitive, information must be perfectly accessible to all participants, allowing the coordination of self-interest seeking participants to distribute economic gains.
• On the other hand, the state is an organization responsible for creating and enforcing rules and regulations that coordinate economic activities. The state has legitimate coercive power to enforce these rules and regulations and can conscript resources, such as through taxation or military drafts, to provide public goods like defense, security, law and justice, and infrastructure that may not be supplied by a free market.
• Markets and states are inseparable, as market transactions require conflict resolution mechanisms and property rights enforcement, which are provided by the state. The state also relies on resources and transaction proceeds from market participants. Thus, a nationwide market and a nation state are the core organizations in the modern world. Economic systems differ based on their combinations of state and market sizes and forms, raising the question of which combination best promotes development.
• Orthodox and neoclassical economics, originating from Adam Smith, argue that competition in a free market leads to an allocation of resources that achieves a social optimum. This theory is based on the market mechanism of adjusting prices to balance supply and demand for a commodity or service. When a homogenous product is sold at different prices by different sellers, buyers will gravitate toward the lowest priced seller, causing prices to adjust until demand equals supply. This equilibrium, according to neoclassical economics, represents efficient resource allocation and maximizes societal welfare.

Market Failure

• Market failure occurs when the equilibrium reached through market forces does not result in the most socially desirable outcome. In a perfect market, there would be no need for government intervention, as the market would allocate resources efficiently. However, markets often fail to achieve optimal outcomes, which necessitates government involvement to correct these failures.
• Governments, especially in developing economies, often acquire monopoly characteristics while drawing constitutionally determined legitimate coercive powers. There is, thus, a strong incentive for the size of governments to expand if only for the sake of greater power and position of bureaucrats. The government is a repository of a large body of information. Often, there lies an incentive to manipulate this information that ordinary citizens may find difficult to comprehend, in favour of certain goods. For example, national security issues may be exaggerated to increase the size of military, while fiscal profligacy concerns may be underplayed. Unlike in a private sector entity, the perception on bankruptcy of governments may be nuanced and difficult to visualise. In the absence of profit incentives and weak perception on bankruptcy, government organisations are susceptible to falter on efficiency issues. Further, bureaucrats and pressure groups with vested interests may resist expenditure reduction, or, budget re-allocations from one category of public goods to another. These conditions conspire to yield an oversupply of unnecessary public goods, often, in combination with undersupply of public goods that are critically needed for economic development. Such inefficient budget allocation is a typical case of government failure.
• Market mechanisms tend to work well for private goods, where individual property rights are well-defined, and people must pay to use the goods or services. However, market failure is more common in the provision of public goods. Public goods, such as law enforcement and judicial services, can be utilized by many people simultaneously (non-rivalry) and are difficult to restrict only to those who pay for them (non-excludability). This leads to the "free rider" problem, where individuals use public goods without contributing to their cost. Private entities seeking profit are unlikely to provide such goods, so the government must step in to supply them.
• Advances in areas of political economy, public choice theory, theory of incentives, etc., throw some light on the behaviour of governments constituted of political leaders who would follow an objective to maximise their likelihood of continuing in office. In such a situation, budgetary allocations among various public goods may be based on considerations that are significantly different from what may contribute to maximise gains in social and economic welfare. In particular, issues that strengthen political support often hijack the economic welfare agenda. For example, a public good such as basic scientific research that benefits society as a whole is likely to be undersupplied. Benefits from such goods may likely be distributed widely among a large number of people in future. But, it is unlikely that a strong pressure group may emerge to press forth this demand. On the other hand, pressure groups may emerge easily for some infrastructure projects (that may could, also, result in oversupply) if there exists an opportunity for large private benefits to a few contractors and / or a relatively small number of residents in a community.
• In reality, goods and services often fall on a spectrum between purely public and purely private. For example, cars provide private transportation benefits to their owners, but they also produce negative externalities, such as pollution and accidents. The market may over-produce cars, resulting in a suboptimal social outcome. To address this market failure, the government may impose taxes or fees to internalize the negative externalities.
• Often, the supply of public goods is determined through a political process, and there is no guarantee that this supply will be socially optimal. It is a commonly held view that supply shortages in public goods present a major bottleneck for growth in developing economies. However, the dangers in oversupply of public good may hardly be overstated. It must be recognised that the supply of public goods entails costs that are ultimately financed through taxation. If a government activity designed to correct for market failure entails higher budgetary cost than social benefits from that corrective measure, it may likely result in oversupply. In addition, governments in developing economies are prone to oversupply public goods of relatively low social demand, often to the neglect of those vital for economic development.
• Market failure can also occur in situations where the conditions for perfect competition are not met, such as when there is imperfect information among market participants, or when a single buyer or seller can influence market prices. Information asymmetries between buyers and sellers can lead to suboptimal market outcomes or even a complete lack of transactions. Government intervention may be necessary to address these issues, such as through licensing requirements, guarantees, or subsidies.
• When market power is concentrated, such as in monopolies or monopsonies, government intervention may be necessary to prevent price manipulation or other anti-competitive practices. On the other hand, some industries with network-based systems or increasing returns to scale, such as utilities, may be more efficiently served by regional monopolies. In these cases, the government may regulate prices or provide services through public enterprises to ensure fair pricing.
• Government actions to address market failures often have public good characteristics. However, another crucial role of government is to promote equity, a social objective as important as efficiency. Market mechanisms alone are unlikely to achieve a socially desirable income distribution, so governments must use their coercive power to redistribute resources. This can be achieved through policies such as progressive taxation and social security programs, which can improve overall social welfare and promote stability.

Government Failure

• Government failure often occurs when the supply of public goods is determined through a political process, which may not guarantee socially optimal supply. Supply shortages in public goods can hinder growth in developing economies, but the dangers of oversupply should not be understated. Supplying public goods incurs costs that are financed through taxation; if a government activity to correct market failure has a higher budgetary cost than the social benefits it provides, it may lead to oversupply. Governments in developing economies are more likely to oversupply public goods with low social demand, neglecting those that are vital for economic development.
• Political economy, public choice theory, and incentive theory can help explain the behavior of governments that prioritize their continuation in office. In these situations, budget allocations for public goods might be based on factors that differ from those that would maximize social and economic welfare. For instance, issues that strengthen political support can overshadow economic welfare concerns. A public good like basic scientific research that benefits society as a whole is likely to be undersupplied because it does not create a strong pressure group to advocate for it. Conversely, pressure groups may form around infrastructure projects that provide large private benefits to a small number of people, leading to oversupply.
• Governments, particularly in developing economies, often acquire monopoly characteristics through their constitutionally determined coercive powers. This creates an incentive for governments to expand for the sake of increasing the power and position of bureaucrats. Government organizations are prone to falter on efficiency issues due to the absence of profit incentives and weak perceptions of bankruptcy. Bureaucrats and pressure groups with vested interests may resist expenditure reduction or budget reallocation, resulting in an oversupply of unnecessary public goods and an undersupply of those needed for economic development. This inefficient budget allocation is a typical example of government failure.
• Government failure is not limited to budgetary misuse; it can also stem from regulatory interventions that bias resource allocations. Regulations can contribute positively to society, such as by controlling pollution and promoting vehicular safety. However, over time, regulations can become entrenched, and firms protected by regulation may support politicians in exchange for the continuation of the regulation. Regulatory agencies can also become avenues for corrupt practices.
• It is important to recognize that markets and governments are not substitutes; they play complementary roles. Developing societies need to shift their perception of markets and governments as being parasitic to one where they share a predominantly symbiotic relationship.

The Role of Community in Development

• In the continually evolving nature of societies, economic institutions, such as the market and the state, always face a distinct probability of failure on certain aspects. Such failures occur on account of the relative inertia of the institutions that prevents them from keeping pace with the ever-changing needs of a society. However, failures in these circumstances also provide the requisite incentive to look for tools and options to set them right.
• Asymmetry in information across various agents such as NGOs (NonGovernmental Organizations), Civil Society groups, etc. is a typical reason for several lapses observed in markets or governments. There is growing consensus that democratic systems, are, perhaps best suited to acknowledge the lapses and facilitate appropriate triggers for correctives. Often, ideologies that have withstood the tests of time, and may come to be grounded in religious (customary) practices, also play a vital role.
• Up till now, you have studied the role of the market in development and the success and failure to effectively deal with development. Besides, these two actors, today, community and community based organizations also play an important role. In your locality you might have seen that community organisations like youth clubs, mahila mandals, and panchayats collect fund for various welfare activities, such as education of the poor, healthcare of the poor, preparation of a common club house, etc. Thus, community organisations now play an important role in development.
• Asymmetry in information presents a dichotomy in the incentives facing differing agents and may give rise to the problem of moral hazard. Simply stated, moral hazard refers to a situation where an individual’s rational actions to preserve her self interest conflicts with another agent’s (rational) actions. The other agent is also acting in her own self-interest. Self interest, however, risks a connotation of selfishness, and may not be the best description of an individuals’ disposition as an economic agent. The frequency of moral hazard situations, it is believed, may be reduced among people when they undergo intense personal interactions. Such interactions nurture mutual trust, thus, enhancing individual capacity to predict another’s behaviour. Further, these may serve as useful and effective brakes in preventing a downward slide along the slippery path of moral hazard. Intense personal interactions bring forth issues of mutual interest that often result in the formation of communities held together by mutual trust.
• Theoretically, community may have a wide domain ranging from the family to the national community. It is not uncommon to also hear about an international community. In developing economies, however, a community typically signifies a tribe or, a village with individuals bonded by blood and locational affinities. According to Populin, “a community is a unit of social and territorial organisation in which people live, work and attend school and carry on many other activities which are a part of daily living”. In relatively urbanised developed economies, community relationships (or, interest groups) are formed through channels such as workplace, schools, colleges, church, sport, hobby clubs, etc. Communities often exhibit a significant influence on business transactions and political activities. Recent controversies relating to land acquisition for industrialisation have queered the pitch by portraying certain communities as fetters on modernisation. However, these communities are critical to avert failures in the market mechanism and in the role of the state to support development.
• Three important reasons for which community participation in the development process become essential, are as follows
  (i) At first, the market mechanism co-ordinates the actions of profit seeking individuals through competition, by signalling price changes
  (ii) Second, the state induces people to adjust resource allocation by using coercive powers at its command
  (iii) Last, a community, however, works differently from a market, or, a state, to guide members towards voluntary consensual cooperation.
• Community participation is a process by which a community identifies its needs, or, objectives, gives priorities to them, develops the confidence and will to work at them, finds resources to deal with them, and, in doing so, extends and develops cooperative and collaborative attitudes and practices within the community.
• In several subtle ways, the community and state may assume similar forms. For example, a village is a community where villagers cooperate voluntarily. However, villagers may chose to authorise particular individuals to exercise certain coercive powers in the administration of village affairs when it assumes the form of a small state. However, a community and a state are functionally separable. In what follows, we attempt to illustrate the role of community in development by: (a) fostering cooperative action; (b) promoting trust as social capital; and (c) supply of local public goods.

Cooperation

• The importance of cooperation to improve efficiency in resource allocation and improve benefits (or minimise costs to individuals), may be illustrated by what is popularly known as the Prisoners’ dilemma in game theory. The Prisoners’ Dilemma (in this specific situation, highlighting benefits from cooperation) may be illustrated as follows. Assume that there are two suspects (A and B) who have been charged with committing a crime. They are taken into custody and confined in separate cells. In their cells, they are respectively interrogated by a prosecutor. The prosecutor threatens each suspect with a heavy penalty, should he continue to deny the charges, while the other suspect confesses. Alternatively, the interrogator tempts each suspect with a small reward, should he confess to the offence while the other party maintains denial. A typical pay-off matrix for such a game may be the following.
  
• Both A and B are faced with two strategic choices, to either cooperate (with each other) or not. Note that cooperation here refers to cooperation between the suspects, not, cooperation of a suspect with the investigation agency. Non cooperation of a suspect with the other may be interpreted as defection from the community. If both A and B cooperate with each other and continue to deny, they may be set free and enjoy a positive pay off of 3 units each. Alternatively, if A decides to cooperate while B chooses to defect, then A ends with a penalty of 5 units while B gets a small reward of 1 unit. The situation gets reversed if A decides to defect while B chooses to cooperate. Note that the suspects are isolated and act simultaneously without any information on other’s action. If both A and B choose to defect, they end up with a penalty of 3 units each.
• Typically, in such a situation, suspects would adopt a maximin approach whereby they adopt a strategy that maximises their pay-off from among the minimum pay-offs for their alternative strategies. The minimum expected pay off if A chooses to cooperate is -5, while the minimum pay off if he chooses to defect is -3. The maximum between these two pay-off (that is -5 and -3), is -3 and, therefore, A chooses to exercise the strategy which assures this, and he defects. A similar approach is adopted by B.As a result both end up defecting and with a penalty of 3 units each. Thus, while it is possible for the two suspects to gain 3 units each, in the absence of cooperation (alternatively interpreted as presence of moral hazard) they end up with penalties.
• This example of Prisoner’s Dilemma illustrates how inability to establish cooperative relationships, due to the absence of communication and trust, may push society to a worse outcome than hitherto possible.

Trust as Social Capital

• The example cited above pertains to an undesirable activity, or, a public bad, but, contrary to what one may like to believe, such situations occur with greater frequency in the context of public goods. Situation analogous to Prisoners’ Dilemma are faced commonly by various transacting agents in a society. Is it then possible to improve the outcome of economic transactions say, by use of the legal apparatus provided by the state? In theory, the dilemma can be prevented, if contractual terms and penal clauses against possible violation (non cooperation) could be detailed in a written agreement. This further envisages that a mechanism to appeal for mediation by a third party, such as a court, is possible should a conflict arise. In practice, however, it is difficult to lay down a complete contract detailing all possible situations of conflict, say about product quality, delivery time, etc. with all considerations for future contingencies. The problem is especially confounding for new products that may be technologically complicated and where it is difficult to predict beforehand the contingencies that may arise in development and production stages. In hiring labour, it may be difficult to express clearly, and, in detail, the specific skills and knowledge that a prospective employee may be required to possess. Contingencies that may possibly influence such a transaction are theoretically infinite. Thus, it may not be possible to stipulate, in advance, all appropriate counter measures for all contingencies under the ‘bounded rationality’ of human beings.
• Next, third party mediation, especially formal court procedures may entail significant costs. This could often be inhibiting for arbitration on conflicts involving small sums of money. The scale of production and transactions may be typically small in developing economies. Thus, in developing economies, legal means may have only limited utility in solving a typical problem of prisoners’ dilemma. The difficulty may be compounded in economies where formal laws and judicial system are less than adequately evolved.

Supply of Local Public Goods

• Mutual trust gained from personal interaction comprises social capital for the community. Such trust is a form of local public good that benefits a limited group. In this sense, a community possess a comparative advantage, over markets, or, even a state, in supply of local public goods. This supplements the comparative advantage of a market mechanism to supply private goods, and, of a state to supply national public goods. Indeed, a community may be most effective in discouraging free riding (or identifying and excluding potential free riders).
• While there is always some opportunity for free riding (that is, enjoying the benefits of say a village road, but not contributing to its costs, say voluntary labour), trust forged amongst members of a community often works towards raising the supply of local public goods to a social optimum. Efficiency in this supply depends on the effectiveness of the likely social sanctions facing those who violate the community’s implicit agreement. Any social formation lacking the requisite, or critical, level of trust capital would fail to provision adequately for local public goods. A higher level of government, like the state, then has to intervene to bridge this deficiency. In most cases this inevitably leads to undersupply of local public goods or high cost, inefficient provisioning.

Dualism in Development Dynamics

In the previous section you studied the role of various actors such as the market, state, and community in development dynamics. Another important aspect of development dynamics is dualism, where two opposite system coexist. The two types of dualism discussed in this section of development dynamics are

• Traditional versus modern sector
• The one sector model versus the dual sector model of growth

The concept of economic development involves more than just an increase in income and consumption levels. It also includes aspects that contribute to a better quality of life, such as changes in how people live and interact, manage their desires through commercialization and urbanization, and organize their political roles. This process of change, which involves the evolution of institutions and customs, is referred to as modernization.

• Economic change and modernization are often seen as independent processes that interact in various ways. These interactions can either synergize or hinder development under different conditions.
• Consider an economy with two sectors: traditional and modern. The modern sector is characterized by advanced technology and higher productivity, but people in this sector are geographically dispersed and have limited information about each other. The traditional sector, on the other hand, uses less productive technology but people in this sector are closer geographically and have better information about one another.
• In this economy, people may need loans to increase consumption or invest in their activities. Lenders may be hesitant to provide loans to those without collateral, but the traditional sector's superior information allows for better monitoring of borrowers and potentially better access to credit. The modern sector, however, may offer more productive credit, although with higher risks.
• The dynamics of development in this model involve a two-way interaction between growth and institutional change. Growth depends on the number of people who adopt new technology, but it may be limited by the differences between the traditional and modern sectors. As the economy grows, capital becomes more abundant, and interest rates fall, reducing the advantages of the traditional sector in providing loans. This may encourage people to migrate to the modern sector, leading to faster development.
• In contrast to the dual-sector model, the one-sector model, also known as the Ramsey-Cass-Koopmans (RCK) model, represents the economy as an optimal control problem, focusing on rational and utility-maximizing individuals. Growth in this model is primarily determined by savings that are reinvested in the economy.
• The dual-sector model, developed by Lewis, is designed to explain the growth of a developing economy, consisting of a traditional agricultural sector and a modern industrial sector. The agricultural sector is characterized by surplus labor, low wages, and low productivity, while the industrial sector is characterized by higher wages and increasing productivity. Growth in this model is driven by the continuous supply of labor from the agricultural sector. As workers transition from agriculture to industry, general welfare and productivity continue to rise.
• However, reality is more complex than the theory suggests. The introduction of new productivity-enhancing technologies in agriculture and the intensive use of labor can create more surplus labor. The wage gap between the agricultural and industrial sectors should be sufficient to incentivize transitions between the sectors. Industrial sector expansion may halt when this monetary incentive is not strong enough. In practice, assumptions about rationality, perfect information, and unlimited capital formation potential in the industry may not be realized. Nonetheless, the dual-sector model provides a general theory of labor transitioning to the modern sector in developing economies.

Conclusion

In conclusion, the dynamics of development involve the interplay of various actors, such as the government, the market, and the community. While the market and state play crucial roles in economic development and resource allocation, they are prone to failures and inefficiencies, necessitating the need for community involvement. Communities foster cooperation, promote trust and social capital, and contribute to the supply of local public goods. Understanding the roles and interactions of these actors is essential for promoting sustainable and inclusive development, as well as addressing the challenges posed by market and government failures.

Frequently Asked Questions (FAQs) of Development Dynamics

What is the role of the market in economic development?

The market plays a crucial role in economic development by coordinating voluntary transactions between producers and consumers of goods and services. It helps in the allocation of resources and contributes to the distribution of economic gains among self-interest seeking participants.

What is the role of the state in economic development?

The state plays an essential role in economic development by laying down rules and regulations for coordinating economic activities. It enforces these rules and regulations and ensures the provisioning of public goods, such as defense, security, law and justice, and infrastructure, which may not be supplied by a free market.

What is market failure?

Market failure occurs when the market equilibrium diverges from the point of optimal resource allocation and maximum social welfare. This can happen due to the inability of markets to provide public goods, information asymmetry, or concentration of market power, among other factors.

What is government failure?

Government failure occurs when the government's actions to correct market failures lead to inefficient allocation of resources or have negative impacts on societal welfare. This can happen due to misuse of budgetary allocations, inappropriate regulations, or inefficient provision of public goods and services.

How does the community play a role in development?

The community plays a significant role in development by fostering cooperative action, promoting trust as social capital, and supplying local public goods. Community participation helps in identifying community needs or objectives, prioritizing them, and developing collaborative attitudes and practices within the community to address those needs effectively.