Notes prepared by: Jayan Jose Thomas
Please do not circulate without the author’s permission
State vs. Market Debate
As can be seen from Table, India, China and South Korea were at similar levels of economic
development in 1960. In fact, South Korea was then an extremely poor country, struggling
to recover from the destructive impacts of the Korean War. However, by 1980, South Korea
along with the other East Asian tiger economies of Taiwan, Hong Kong and Singapore had
surged ahead in economic growth. The gains made by China and India in economic growth
during 1960-1980 had been far less impressive. It is worth noting that China was behind
India in per capita income in 1980. However, after another (almost) four decades, in 2016,
the picture changed yet again. South Korea had by then become one of the most advanced
economies in the world. While India’s economic growth had accelerated, it was left far
behind by not only South Korea but also China.
What explains such long-term changes in economic growth and development?
GDP Per capita current US $
1960 1980 2016
India 81 264 1710
China 90 195 8123
South Korea 94 1704 27538
(Source: World Development Indicators)
The Debate in Economics
There is an intense debate in economics as to what determines the success of a country in
economic growth and also in distribution. On the one side is the argument that free markets
and free trade are fundamental to economic progress of countries. The contention on the
other side, however, is that free markets and free trade have not delivered beneficial results
1
always and everywhere, and therefore, some degree of intervention from the government is
necessary for economic development.
The argument in favour of free markets was put forward for the first time by Adam Smith,
the Scottish moral philosopher, in 1776. In his highly influential book The Wealth of Nations,
which laid out the guiding principles for modern economic theory, Adam Smith stressed the
importance of freedom, self-interest and competition for fostering economic growth.
According to Adam Smith, the key to maximizing production is to give people economic
freedom – freedom for the movement of labour, capital, money and goods, and also the
freedom to trade with each other, with limited interference from the state or government or
some other central agency. Adam Smith favoured competition over monopoly, and he was
particularly against the mercantilists (trading firms such as the East India Company), which
had monopolized commerce and controlled political power in Britain during the 18th
century.
How does an economy comprising millions of agents – buyers, sellers, workers, firms – get
to take the right decisions on questions such as what and how much to produce, and where
and by whom. Adam Smith argues that the ‘invisible hand’ of free markets ensure that these
are done. Prices, and not commands from a central agency, will play the coordinating role in
an economy. Prices transmit information about the supply and demand conditions in an
economy. If the price of vegetables rises sharply in the local market, it may be an indication
that the domestic production and availability of vegetables may have suddenly dipped due to
certain factors. Prices give signals to producers and consumers about their preferred courses
of action. The fast rates of growth of energy prices have encouraged the research and
development of non-conventional energy sources, particularly in the US. A rise in meat
prices may compel consumers to seek cheaper sources of proteins. Relative prices (wages
relative to the price of capital) determine who gets how much in the distribution.
Adam Smith emphasized the importance of freedom, competition and self-interest. “It is not
from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but
from their regard to their own interest. We address ourselves not to their humanity, but to
their self-love.”
2
Prices that emerge from voluntary exchanges between agents who are guided by their own
self-interest.
Arguing that countries should trade with each other, Adam Smith advocated the removal of
the barriers for trade between France and England. Later, in 1815, David Ricardo put
forward the ‘theory of comparative advantage’ to explain why it is mutually beneficial for
countries to trade with each other. In his famous example, Ricardo showed that Portugal
might have an absolute advantage over England in the production of wine as well cloth. In
other words, the production of a unit of wine and a unit of cloth may both require fewer
labour hours in Portugal than in England. Yet, Ricardo argued, Portugal should not try to
produce both the goods given that the availability of labour in that country is limited.
He further argued that both countries would benefit if England were to produce cloth and
Portugal were to produce wine and they traded their goods with each other. This was
because Portugal’s advantages vis-à-vis England were more in the production of wine than in
the production of cloth. The opportunity cost incurred will be greater if the limited number
of workers from Portugal were employed in the production of cloth and rather than of wine.
Therefore, according to Ricardo, Portugal’s comparative advantage was in the production of
wine while England’s comparative advantage was in the production of cloth.
A newer version of the Ricardo’s argument in favour of free trade can be seen in the
Heckscher-Ohlin- Samuelson theory (or HOS theory) (named after the economists who
pioneered this theory: Eli Heckscher, Bertil Ohlin and Paul Samuelson). According to HOS
theory, a country’s comparative advantage derives from the relative abundance of factors of
production, labour and capital, in the economy. If a country has a relative abundance of
labour, it should produce goods that intensively use labour. Between India and the US, the
HOS theory would argue that India should produce labour-intensive products such as
garments or leather, while the US should manufacture capital- or skill-intensive products
such as semiconductors or steel.
However, the actual experience of the market mechanism has been far less successful.
3
The debate on the relative merits of state- or government-led development vis-à-vis market-
led development has been a long-standing one. More than its academic relevance, this debate
has had important implications in the sphere of policy making. Beginning in the 1950s, a
number of developing or third world countries including India, which had been newly freed
from colonialism, embarked on a path of state-led development. However, by the 1980s or
1990s, most of these countries liberalized their economies and adopted economies policies
that were market-friendly or even market-led. An understanding of the state vis-à-vis market
debate is important for making sense of this transition.
State-led development in its extreme version – also called the ‘command economy’ --
implies a development model in which the state plays the central role in economic decision-
making. On the contrary, in its extreme version, the market-led economy is one in which
there are very little controls on the operation of free markets; the private sector is the
dominant player and the government carries out only its basic functions. In a command
economy, the most important signals for resource allocation are the commands from the
administrative hierarchy, whereas in a market economy, prices from the market are the
signals that determine the allocation of resources1
The functions of the state or government:
State’s role in maintaining law and order and in providing public goods
It is generally agreed that the basic functions of the government in any society include the
maintenance of law and order and the provision of ‘public goods’, including the building of
the necessary infrastructure (such as roads, bridges, railways and electricity).2 In fact, on the
emergence and early functions of state as an institution, Johnson (1982) had this to say:
“The state as an institution is as old as organized human society. Until approximately the
nineteenth century, states everywhere performed more or less the same functions that make
1
See Naughton (1995), p.25
2
Public goods are goods that are beneficial to a wide range of people in the society: for
example, research and development. It is unlikely that a private entrepreneur will start
production of such goods because she/he is aware that the fruits of her efforts, say in
research and development, will easily be accessed by her rival entrepreneurs as well.
4
large-scale social organization possible but that individuals or families or villages cannot
perform for themselves. These functions included defense, road building, water conservancy,
the mining of coins, and the administration of justice” (Johnson, 1982, pp. 18-19).
The regulatory function of the state
With the emergence of industrial capitalism in western nations, the state was compelled to
shoulder greater responsibilities. Johnson (1982, p. 19) writes: “towards the end of the
nineteenth century the state took on regulatory functions in the interest of maintaining
competition, consumer protection, and so forth”. The state as an agent to control and
mediate the market forces (such as regulating unwarranted rise in prices, monopoly behavior,
and so on) has played an important role in the capitalist or market-led economies such as the
US.
State as an agent of redistribution
State has also been an agent of redistribution -- redistributing wealth, income or resources
from those who are relatively rich to those who are relatively poor. The way the state has
carried out this role differed across countries and over time – partly determined by the
ideological orientation and class bias of the state. Revolutionary redistributive policies have
been carried out in some countries ruled by parties with extreme socialist (or Marxist)
ideologies. Property relations have been radically altered in them, often as a response to the
high inequalities that existed in these countries before the revolution.
But the state has intervened as an agent of redistribution also in other countries, including
capitalist countries committed to market-led growth. This intervention is through the state’s
expenditures on social sectors, mainly health and education, to provide social security
benefits for its citizens. Remember how the Keynesian revolution emphasized the role of
government expenditures in stabilizing the economy and in the building of social and
physical infrastructure. It is well recognized that the policies inspired by Keynesianism came
to the aid of the capitalist system during the 1960s.3
3
See ‘The Economy: We are all Keynesians now’, Time Magazine, Cover Story, December 31,
1965.
5
Thus it can be seen that the state has performed the above-discussed roles – maintaining law
and order, providing public goods, regulation and redistribution -- both in state-led
economies and in market-led economies. As can be seen in the Table below, government
expenditures as per cent of GDP have been quite high in capitalist countries such as the US
and Germany.
Table 1: Taxes and Government Expenditures as % of GDP, Selected Countries, 2011
Country Taxes as % GDP Govt. expenditure as % GDP
Cuba 41.2 78.1
Sweden 47.9 52.5
United Kingdom 38.9 47.3
Germany 40.6 43.7
Norway 42.1 40.2
United States 26.9 38.9
India 18.6 27.2
China 18 20.8
Hong Kong 13 18.6
Source: www.wilkipedia based on the 2011 Index of Economic Freedom by The Heritage
Foundation and The Wall Street Journal.
Developmental role of the state:
Compared to the earlier discussed roles of the state, the intervention of the state in industrial
or economic development has been debated far more intensely.
The orthodox neoclassical theory and the supporters of free market believe that there is very
little role for the government in the industrial and the overall economic development of a
country. They believe that the major investments and economic decisions in the economy
will be made by the private sector (and not by the government). Prices will be determined
freely, through the interaction of the forces of supply and demand (and not through
government orders or regulations). And private entrepreneurs make their investment
decisions based on the price signals received from the market (for instance, if prices of steel
go up, an entrepreneur will have an incentive to invest in steel making).
6
What kind of industries should a country try to build? The supporters of free market swear
by the theory of comparative advantage. This theory argues that a country’s comparative
advantage is determined by its relative abundance of factors of production (importantly
labour or capital).4 Thus a labour-surplus country like India has a comparative advantage in
the production of labour- intensive goods such as textiles or food products, but not in the
production of capital-intensive or skill-intensive goods (such as steel or semiconductors).
The operation of the market mechanism, in itself, will ensure that industrial development
proceeds as determined by the comparative advantage. The government’s role in industrial
development should be limited to allowing the free operation of market forces – thus in
helping to establish the ‘right’ relative prices of factors of production (wages for labour and
interest rates for capital).
As per the comparative advantage theory, a labour surplus country like India (in the 1950s or
even today) should not have invested in the manufacture of technology-intensive or capital-
intensive products such as steel or semiconductors. Supporters of free markets argue that a
developing country like India will make the transition from a low-technology industrial
structure to a high-technology industrial structure automatically if markets are allowed to
operate freely.
However, development experiences of most countries indicate that this transition is neither
easy nor automatic. Technology is a big barrier. How do developing countries gain access to
advanced technologies? Multinational companies will not transfer advanced technologies to
developing nations.
In particular, the experiences of East Asian countries like South Korea and Taiwan suggest
that government played a key role in their transition from low-technology industries to high-
technology industries. Alice Amsden (1989), who studied South Korean industrialization,
notes that the early industrializations of Britain, continental Europe and of the US (during
the 18th and 19th centuries) were driven by invention or innovation. On the other hand, in
the case of countries that industrialized after 1950, learning of technologies developed
4
The theory of comparative advantage refers to the ability of an individual or country to
produce a good or service at a lower opportunity cost than another party.
7
elsewhere was the key driver of industrial growth. The role of the state was crucial in
industrialization based on the learning of technologies.
In East Asian countries, the state did not play the role of an entrepreneur in industrial
development. Instead, the state helped large, domestically owned private enterprises (such as
zaibatsu in Japan or chaebol in South Korea) to enter into and expand in newer areas of
industry. The state achieved this not by getting relative prices right, but, on the other hand,
by “getting relative prices ‘wrong’”5. That is, the state provided subsidies to the private
players (giving subsidized capital in a labour abundant country is equivalent to getting the
relative prices wrong) (see Amsden (1989, 1990) for details). Johnson (1982) points out how
the Japanese government’s policies during that country’s phase of industrialization deviated
from the mainstream economic principles. He quotes a Japanese scholar to show that these
policies were inspired by the “science of the Japanese economy” rather than “economics
generally” because the policy makers believed that economics should have “national
grammars” (Johnson, 1982, p.26).
The role of the state in industrial development has been much bigger in ‘command
economies’ such as Soviet Union or China before 1978. In these economies, the state has
also been the most important entrepreneur in industry. Public sector units under
government ownership have been the major producers of industrial goods in the country. At
the same time, the government also imposes a range of controls on the operations of the
markets. They range from internal controls on the operation of private domestic firms (eg. the
requirement of licensing to regulate production expansion plans) to controls on external
trade (imports from and exports to foreign countries) and external capital movements (flow
of capital into and out of the country).
From State to Markets
The extent of state control over the economy varies across countries. The control of the
state over the economy was extremely high in the former Soviet Union and China during the
Maoist period (from 1949 to 1978), and it still is high in Cuba and North Korea today. The
private sector’s role in these economies has been extremely limited. The development paths
5
See Amsden (1990), p. 16.
8
adopted by many developing countries since the 1950s also involved high degree of state
intervention although the private sector was not completely excluded in these economies.
State-led development in India since 1950 is a good example.
It may be noted that during the 1950s and 1960s, there was a high degree of
consensus in the academic and policy spheres on the need for planning or state intervention
in the development of third-world countries. During the colonial period, most of these third-
world countries (like India) were forced to follow a policy of free trade. Free trade suited the
interests of the imperial power (say Britain) but left the colonized country in a state of
underdevelopment. The colonies exported primary products or raw material such as cotton
and imported manufactured goods (say cloth) from western countries. However, the prices
of primary products, which the colonies exported, were on a continuous decline over the
years. This led to ‘export pessimism’ among third-world countries. At the same time, the
urgent tasks of third-world development required a sharp increase in savings rate and capital
formation in these countries. Development planning was considered to be essential for
achieving these. This was the context for state-led development adopted by India and a
number of other countries from the 1950s.
However by the late 1960s and 1970s, the state-led model of development met with
a number of problems. There were large inefficiencies associated with public sector
investments. The government’s distribution of subsidies and licenses to private players often
involved corruption. The large government expenditures involved in state-led development
resulted in the widening of government deficits and debts.6 These problems aggravated with
the oil crises of the 1970s. Consequently, the consensus in academic and policy circles tilted
in favour of market-led development (from state-led development of the 1950s and 1960s).
Partly under pressures or guidance from international agencies such as the International
Monetary Fund (IMF) and the World Bank, many third world countries began liberalizing
their economies from the 1970s. In India the transition from a state-led economy to a
market-led economy began in the late 1970s, and this transition was more marked since
1991.
Which is a better system?
6
Loosely defined, government budget deficit refers to the excess of government expenditure
over government revenue. Taxes are the major source of government revenues.
9
Many argue that in India, the opening up of the economy to market competition especially
international competition has increased efficiency of domestic firms. For instance, in India’s
telecommunications sector, the liberalization years have, it appears, been a period of
improved efficiency and reduced (telecommunication) call charges.
However, the withdrawal of the state/government from various sectors of the
economy has led to new set of problems. In particular, the gradual abandoning of the
government of its responsibility to provide social security benefits – health and education –
especially for the poor has resulted in increased poverty and widening inequalities in several
countries. It may be noted that even in the case of India’s telecom sector, the expansion of
the telecom network has been much slower in the rural areas compared to the big cities and
urban areas. Small entrepreneurs and peasants will suffer when the government withdraws
subsidies and other benefits targeted at these groups.
It is also important to note that market-led growth strategy may be beneficial for a
country that has already achieved some degree of development. But does that strategy work
well for a country that is yet to begin its development transformation (for example, India in
the 1950s)? Note the argument by Ha Joon Chang (2003) that the early development paths
followed by the advanced countries (such as the US during the 19th century) involved high
degree of protection and promotion of domestic industries by government policies. By
denying such policies for developing countries, the US and other advanced nations are
“kicking away the ladder” with which they themselves had climbed up the development path
(Chang, 2003).
Which is the more appropriate development model – one led by state or the one led
by markets? This is a highly debatable question. There are merits in both the models. At the
same time, just as there are government failures there are also market failures. Think of the
2008-09 global financial crisis, which was largely a result of the government abandoning its
role of regulating the markets. Probably a country needs a combination of both – state and
markets. In this course, we look more closely at the Indian economy and try to understand
the exact role of state and markets in the country’s development.
References:
10
Amsden, Alice H. (1989), Asia’s Next Giant - South Korea and Late Industrialisation, Oxford
University Press, New York.
Amsden, Alice H. (1990), ‘Third World Industrialization: ‘Global Fordism’ or a New
Model?’, New Left Review, Vol. 182, July-August.
Johnson, Chalmers (1982), MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-
1975, Stanford University Press, California. Chapter 1, pp. 3-34.
Naughton, Barry (1995), Growing Out of the Plan: Chinese Economic Reform 1978-1993,
Cambridge University Press, Cambridge, UK.
Wade, Robert (1990), Governing the Market: Economic Theory and the Role of Government in East
Asian Industrialization, Princeton University Press, Princeton, New Jersey.
Chang, Ha-Joon (2003), Kicking Away the Ladder: Development Strategy in a Historical Perspective,
Anthem Press, London.
11
