Journal of Economic Perspectives—Volume 4, Number 3—Summer 1990—Pages 25–39

Market Failure and

Government Failure

Mrinal Datta-Chaudhuri

F
or several decades a debate has been raging in development economics
on the relative virtues of the free market as opposed to state interven-
tion. With the help of analytical models of a market economy, the
interventionists demonstrate what they consider serious instances of "market
failure"—that is, the inability of a market economy to reach certain desirable
outcomes in resource use. The protagonists of free markets, on the other hand,
compile impressive lists of ill-conceived and counterproductive policy measures
implemented by the governments of different countries at various times, lead-
ing to wasteful use of resources in their economies.
This debate inevitably remains inconclusive. The analytical results on
"market failure" do not disappear in the face of the evidence that most
governments (or for that matter most economies of less developed countries,
with or without state intervention) have performed rather badly. When there
appears to be scope for improvement over the market outcome, the search for
the appropriate corrective measures goes on. Some protagonists of "govern-
ment failure" question the significance of such market failures; others voice
skepticism about the ability of governments to take any action in the economy
which is not counterproductive; but none of them seems to be able to explain
why a less developed country like India failed to grow during the first half of
this century under a non-interventionist colonial administration. Thus, while
the debate goes on, neither side succeeds in convincing the other.

• Mrinal Datta-Chaudhuri is Professor of Economics at the Delhi School of Economics,

University of Delhi, Delhi, India. He wrote this article while a Visiting Professor of
Economics, Harvard University, Cambridge, Massachusetts.
26 Journal of Economic Perspectives

While this sterile debate continues, experiences accumulated from research

and action in the real world during the last 40 years have led to important new
thinking on the roles of market and non-market institutions in the process of
economic growth. The planned economies of the socialist world have learned
that market institutions are not exclusive to the capitalist mode of production,
and that the threat of entry and the fear of exit remain irreplaceable stimuli for
cost and quality consciousness in production. Researchers in market economies
have learned that price quotations on marketed commodities do not always
carry sufficient information for economic decisions, and that institutions matter.
This paper pieces together some lessons from the development experiences of
the last four decades to enrich our understanding of the role of the state in the
process of economic development.

Theories of Development

Development economics as we know it today, as a distinct discipline within

the economics profession, came into existence in the 1940s. Economists like
Rosenstein-Rodan, Nurske and Kuznets tried to identify the major causes of
economic backwardness, and thereby suggest strategies for economic progress
for the backward economies. These economists, like many others in the profes-
sion, assumed that the state would have to play an important role in raising an
economy out of its backwardness. The success of Keynesian activism in fighting
the Great Depression in the western countries, the success of the Marshall Plan
in engineering the quick reconstruction of the war-damaged economies of
western Europe, and the achievements of the Soviet industrialization drive in
the 1930s had created a virtual intellectual consensus in the world on the
power of the "visible hand."
On the basis of the newly constructed time series data on the national
products of different countries, Kuznets (1955) showed that the process of
economic development was always accompanied by a shifting of the labor force
from low-productivity agriculture to high-productivity manufacturing. But in-
dustrialization required a higher rate of capital accumulation. Nurske (1953)
wrote about the problem of capital accumulation in a poor country. In his
famous doctrine of the "vicious circle of poverty," he said that poor societies
remained poor because with low per capita income they could not supply
enough savings to increase their stocks of reproducible capital.
Rosenstein-Rodan (1943) analyzed the demand side of capital formation.
According to him, the structure of these backward economies was such that
there were not enough incentives for investors to choose the right pace or
pattern of capital accumulation. Rodan said that in a poor economy the size of
the market for industrial products was small and people need to spend most of
 Mrinal Datta-Chaudhuri 27

their incomes on necessities.1 Moreover, he argued that the production pro-

cesses in modern industries were subject to great indivisibilities and economies
of scale. He particularly identified one category of physical capital for special
attention: the social overhead capital like transport, communication, power,
urban infrastructure, and so on. These activities were not only bedeviled by
nonconvexities, but they had to be in place before private entrepreneurs could
decide to install directly productive capital. Borrowing an expression from
Allyn Young (1928), Rodan characterized the entire phenomenon as general-
ized external economies.
It was left to Scitovsky to give a rigorous analytical meaning to Rodan's
concept of external economy. Using the framework of the competitive equilib-
rium and the associated welfare theorems, Scitovsky argued that externalities
arose only when interdependence among economic agents was not mediated
through market transactions. In his highly influential paper, Scitovsky (1954)
concluded that only the externalities arising from intertemporal dependence
amongst firms (which he called "pecuniary external economies") presented a
serious impediment to the growth of a backward economy, if it were to be
propelled by a price-guided system. The implication of the Scitovsky formula-
tion was that the market mechanism could be relied on to take care of the
production problems of an economy, but investment allocation required state
intervention.2 Thus, the state emerged in the role of an investment planner in
a developing country. It was implicitly assumed that once the productive
capacities were created through investment planning, the subsequent problems
of getting output, employment and income out of these investments would
resolve themselves automatically.
This line of analysis led almost every developing country to set up a
planning agency to formulate investment plans based on economy-wide quanti-
tative models. These models varied from country to country in terms of their
levels of disaggregation and their computational techniques, but they were
similar in certain important aspects. They were rich in their specification of
technology and interindustry linkages, but hopelessly deficient in their specifi-
cation of behavioral and institutional issues. Therefore, the economic and the
statistical analysis embodied in these planning exercises did not provide much

1
Although, following Scitovsky, latter-day development economists focussed their attention on
externalities and the resultant suboptimality of the competitive equilibria, Rodan himself was
primarily worried about the inadequate working of the price mechanism in the absence of strong
substitution effects.
2
Externalities occur when a complete set of Arrow-Debreu markets do not exist. Pecuniary
externalities result from the absence of future markets. Recent researches on the working of
economies with incomplete markets (and imperfect information) show that in such situations even
competitive markets fail to optimally perform the required risk-sharing functions. Competitive
equilibria for such an economy are not constrained Pareto-efficient and there exist schemes of
government intervention which can induce Pareto-superior outcomes (Greenwald and Stiglitz,
1986).
28 Journal of Economic Perspectives

guidance as to how these investment plans were to be implemented.3 It was left

to the ingenuity of individual countries to design appropriate mechanisms for
implementation, and different countries drew on their own cultural and histori-
cal experiences in designing their regulatory systems. It is possible to argue
that the performance of the different developing countries can, to a large
extent, be explained by the nature of the regulatory mechanisms they adopted.
This body of theory proved deficient both because of deficiencies due to
their empirical projections based on historical experiences, and because of the
analytical shortcomings of their models of resource allocation. On empirical
matters, the assumption that large productivity gains could not be realized in
agriculture though technological progress proved to be wrong when the fruits
of research in plant genetics became available in the 1960s. Secondly, the
stagnant scenario of world trade, experienced throughout the first half of the
twentieth century, dramatically changed in the 1950s. The phenomenal eco-
nomic growth in the OECD countries during the two decades following the
Korean war led to massive expansion in world trade. Rising wage rates in the
developed countries led to substantial changes in the pattern of the interna-
tional division of labor. Many poor countries, such as South Korea and Taiwan,
could take advantage of the new trade opportunities to become industrialized
in a short period of time.
A more lasting consequence arose from the analytical shortcomings of the
Nurske-Rodan-Scitovsky framework of development economics. Later re-
searchers in the field of economic growth seriously undermined the importance
attached to capital formation in the growth process of an economy. Solow's
(1957) seminal contribution demonstrated that only a small part of the growth
performance of an economy can be explained by the increment in its stock of
reproducible physical capital (or by the employment of a larger number of
workers). Most of the economic growth seems to come from technical progress,
which is essentially the ability of an economic organization to utilize its produc-
tive resources more effectively over time. Much of this ability comes from the
process of learning to operate newly created production facilities in a more
productive way4 or more generally from learning to cope with the rapid
changes in the structure of production which industrial progress must imply.5

3
In the field of development planning one often hears people talking about "a good plan
implemented badly." This dichotomy between the formulation and the implementation of a plan is
usually false. If a plan is supposed to be a feasible action program, then it must have been designed
on the basis of realistic assumptions regarding the expected behavior of economic agents. Difficul-
ties regarding implementation should arise only from unanticipated exogeneous shocks.
4
Arrow (1962) analyzed the implications of acquiring skill through the actual process of operating
production capacities over time.
5
Stiglitz (1987) analyzed the importance of "the frame of mind which is associated with asking 'how
this task can be performed better?' " This has implications not only for decision-making at the firm
and the industry levels, but also for choosing a policy framework in which the industrial economy
can learn to take better advantage of its economic environment.
 Market Failure and Government Failure 29

Traditional development economics paid little attention to such learning

processes and implicitly assumed that whatever technical progress was possible
would automatically come with capital accumulation. The development experi-
ences of the last three decades show that economies differ considerably with
respect to their abilities to learn how to assimilate new techniques and how to
adjust quickly to new lines of production. Moreover, the nature of the indus-
trial organization and the policy environment in which it functions have a
considerable impact on the ability to acquire these learning capabilities. To
illustrate these points the next section will outline the working of the policy
regimes in two economies of Asia—India and South Korea.

Policy Regimes in India and South Korea

At a superficial level, there is a great deal of similarity between the

planning and the regulatory frameworks adopted by these two countries. 6 Both
countries adopted the framework of investment planning with five-year plans
computed on the basis of demand projections and interindustry linkages. In
the 1970s, the size of the public sector as a percentage share of the gross
domestic products of the two countries was roughly the same. The composition
of the public sector in both countries was similar: commercial banking, steel,
power, and many heavy industries were nationalized in India as well as in
South Korea. Both governments intervened heavily in the private sector, using
a mixture of direct and indirect controls. However, the manner in which the
planning and the regulatory mechanisms worked in the two countries was
different in crucial respects. Later, I shall try to explain these differences in
terms of the socio-political characteristics of the two countries. But before doing
that, it is useful to look at the evolution and the working of the two systems.
In the 1950s, India adopted a development strategy which gave investment
planning a dominant role. In certain areas the investment targets were imple-
mented by direct public investments; in others, entrepreneurs in the private
sector were supposed to be induced to make the required investments. In both
fields—managing the public sector as well as regulating the private sector—
India relied on the impressive structure of bureaucracy it had inherited from
the past. The Mughal empire in the Middle Ages had built an elaborate
structure of imperial bureaucracy; the British colonial administration intro-
duced vast improvements in that model of civil administration. In managing
the turmoils of Partition during Independence and in the subsequent task of

6
Starting from comparable levels of poverty in the early 1960s, the economies of South Korea and
India charted widely divergent growth paths for the next three decades. In 1961 India had $73 per
capita income at current prices, while the corresponding figure for South Korea was $180. In 1987
the per capita incomes at current prices for these two countries were $300 and $2690 respectively
(World Bank, 1989).
30 Journal of Economic Perspectives

national building, the established bureaucracy had performed in an impressive

manner.
This bureaucracy had a good deal of experience in implementing rationing
schemes in situations of scarcity. Thus, implementation mechanisms were
designed on the logic of rationing a homogeneous commodity to needy users in
situations of scarcity.7 The Five Year Plans produced aggregate investment
targets for the different sectors of the economy. A number of choice problems
still remained to be solved, such as technique, product mix, location and scale
of individual plants, as well as the class of entrepreneurs to be entrusted with
the job. Moreover, the choice problems were to be solved while keeping in
mind a multiplicity of developmental objectives: growth, employment, interre-
gional equity, self-reliance and control of monopolies. The entire implementa-
tion mechanism was based on the hope that civil servants would use their
discretion in an enlightened manner, and thereby meet the plan targets while
satisfying the various objectives of development.
János Kornai (1982) had spelled out some of the classic syndromes of
investment planning under bureaucratic management. Investment planning
creates shortages, partly because of the deliberate efforts to raise the overall
rate of capital accumulation and partly because of the inevitable uncertainties in
synchronizing planned activities. With assured markets, producers step up
supplies in certain sectors of the economy. The managers of public sector
enterprises produce for the captive market. Given the "soft budget constraint"
under which they operate,8 they are not unduly worried about making losses.
Producers in the private sector also have assured markets. With the legal
barriers to entry instituted by the licensing system, they do not have much
incentive for either cost reduction or quality improvement. Their perceptions,
as businessmen, become more and more fixed towards cornering the rents
associated with the distribution of licenses.9 It seems one needs an environment
of competition even to design an effective organizational structure within a
business enterprise. Over time, the industrial economy becomes wasteful. It
neither generates enough surplus for reinvestment, nor is it able to derive
sufficient dividends in terms of the growth and the equity objectives of the

7
For example, when a famine occurred in any part of the country, officials in charge of the famine
relief instituted rationing schemes for distributing foodgrains to well-defined target groups of
victims on the basis of established need-based norms.
8
Losses incurred by the public sector enterprises are automatically borne by the government. As
such these enterprises are not disciplined by any fear of bankruptcy. Kornai described this situation
as one of decision-making under a "soft budget constraint."
9
Krueger (1974) saw the rent-seeking phenomenon as a shrinking of the production possibility set
due to the withdrawal of resources from production to rent-seeking. Perhaps more important than
the resource cost of rent-seeking are the effects of the policy environment on the perception of
economic agents. In such an environment, producers tend to become obsessed with the short run
gains associated with cornering the licenses at the cost of the long run benefits connected with
technological and managerial improvements.
 Mrinal Datta-Chaudhuri 31

society on its investments. The industrial economy settles into a modest growth
path.
While bureaucratic rationing became the predominant mode of regulation
for the manufacturing industries in India's private sector, India adopted a
market-oriented form of regulation for agriculture. Since it was not practicable
to introduce licensing schemes for the millions of farmers in the country, the
Indian state essentially relied on fiscal measures to raise the prices of crops and
to lower costs of inputs, thereby increasing the profit opportunities in the
farms. This meant giving up on the objectives of interregional and interper-
sonal equities in the context of agricultural development, because only large
farms in favorably located regions could take maximum advantage of these
market incentives. This difference is rather ironic, because nearly 80 percent of
India's population lives in rural areas and the scope for promoting equity is so
much greater in the field of agricultural development than in the context of
modern industries.
The Republic of Korea had a different historical experience to draw upon,
when it came to designing an implementation mechanism. Under the Japanese
occupation before the Second World War, Korea had achieved an impressive
level of industrialization. Much of the produce of these industries was sold
abroad. In fact, it was only in the late 1960s that South Korea's industrial
economy and its export performance (as measured by the shares of manufac-
turing and of exports in the GDP) reached the levels attained by Korea in 1940.
Of course, these industries were then owned and managed by the Japanese; but
Koreans at junior levels acquired valuable skills in managing industries and
trade. By contrast, the Japanese occupation did not use Korean personnel in
running its civil administration. Thus, President Park Chung Hee had to rely
on the new emerging business elite to form his team for development adminis-
tration in the 1960s. Park and his team used a variety of means—financial
incentives, persuasion and sometimes coercion—to influence the behavior of
industrialists and traders. 1 0
Another important difference between South Korea and India relates to
the extent of direct control wielded by the state over the economy's investment
resources. With the resources mobilized through the nationalized banks, for-
eign aid and the public sector, the Korean state in the '70s had direct control
over about two-thirds of the aggregate investment funds available to the

10
Jones and Sakong (1980) describe in some detail how President Park forged his alliance with the
Korean business community. Under the "Special Law for Dealing with Illicit Wealth Accumulation"
most of the country's prominent businessmen were arrested and threatened with confiscation of
their assets. Eventually a deal was struck, whereby the government withdrew criminal prosecution
and the businessmen agreed to set up some basic industries approved by the government. Later on
they were sent abroad under government auspices to negotiate for foreign loans for a number of
investment projects. These businessmen later formed the powerful Federation of Korean Industries
(FKI) which became a partner of President Park's government in fashioning the growth of the
Korean economy.
32 Journal of Economic Perspectives

economy. Korea used credit policy, with differential interest rates ranging from
8 to 34 percent, to channel investments in the desired directions. With this level
of command over the capital market, there was not a great deal of need for
direct intervention in the sphere of commodity production and exchange.
Nevertheless, direct controls, like licensing of production and quantitative
restrictions on imports, were widely used. However, the procedures were
prompt, and the decisions were made by a high-level committee, a feasible
method in a small country (Datta-Chaudhuri, 1981a).
At the enterprise level, the public sector units in Korea had autonomous
management, not burdened with a multiplicity of objectives. In the absence of
any consideration for regional equity, economies of scale were never sacrificed.
Although the producers were given generous protection in the domestic mar-
ket, the incentive structure encouraged expansion on the basis of export
demand. In short, the Korean state was highly interventionist; but the interven-
tion schemes were geared towards developing and supporting the market
economy. The market environment encouraged quick learning as well as cost
and quality consciousness.

Market Institutions and the State

Let us now turn to an aspect of industrial development outside the scope of

investment planning. One of India's success stories has been the development
of the handloom and other products of cottage industries. This came about
largely in response to sales outlets for these products being set up in different
Indian cities by the central and state governments. These state-run sales
establishments, in addition to providing market outlets for small producers
from rural areas, started to interact with their suppliers in a variety of ways.
They started disseminating new techniques of production and new designs to
the producers. They introduced some quality control, and advanced credit.
They also helped to set up a market network which could supply the required
inputs (buttons, dyes, and so on) to the producers in a regular manner.
Independent producers in remote villages could rely on these organizations for
their informational and other market-related needs. To the extent that these
organizations handled all the various links with the outside markets (both
domestic and foreign) reliably and effectively, small producers had little diffi-
culty in producing the required supply.
In the case of South Korea, the trading companies perform a similar role
for independent producers in widely different lines of production. These
trading companies integrate (horizontally) a large number of exchange-related
activities, such as marketing, transport, communication, credit, insurance and
the transfer of technology. In the late 1960s, the government of South Korea
took the first initiative in setting up these organizations. It is said that following
 Market Failure and Government Failure 33

the Japanese example, the government of South Korea set up exactly ten
trading companies as there were in Japan. The phenomenal success of Korea in
exporting manufactured goods cannot be fully understood without appreciat-
ing the role played by these trading companies.
What these examples suggest is that important externalities do exist in
information processing and other exchange-related activities. There also seem
to be significant economies of scale and scope in these activities. The emergence
of the trading companies in East Asia, which horizontally integrated several
exchange-related activities to service the needs of independent producers,
explains the greater success of these economies in promoting labor-intensive
industrial growth. In many other parts of the world, the typical response of an
industrial organization to these externalities has been one of vertical integra-
tion, which led to increased supervision costs, which in turn induced a substitu-
tion of capital for labor (Datta-Chaudhuri, 1981b). We do not fully know why
trading companies do not play as important a role elsewhere as they do in East
Asia. However, the case of South Korea suggest that the promotional and
supportive role of the state in creating these institutions may be an important
factor in their development.
The state-run sales organizations for cottage industry production in India
and the state-promoted but privately held trading companies of South Korea
provide examples of the need for a certain kind of market organization to
support the industrial progress of an economy. These organizations can be said
to constitute the "soft" infrastructure of an industrial economy, which is
different from the "hard" infrastructure emphasized earlier by Rosenstein-
Rodan. The "soft" infrastructure can take a wide variety of institutional forms,
with varying degrees of involvement on the part of the state, to serve the
function of catering to the informational and marketing needs of an industrial
economy (Datta-Chaudhuri, 1981b).

Perceiving and Creating New Markets

Abba Lerner (1972) warned economists against the dangers of assuming

that market institutions sprang up automatically in every place. He correctly
saw the modern economy as the end product of a time-consuming process of
development. In this development process, societies progressively created ap-
propriate institutions so that interpersonal conflicts could be resolved through
economic transactions.
However, producers and traders do not always correctly perceive the
various trade or technological possibilities open to them. There is scope for
imaginative intervention to alter their perceptions and thereby improve the
performance of an economy. Although it is impossible to arrive at general
34 Journal of Economic Perspectives

conclusions of universal validity in this field, it is pertinent to examine some

instances of noteworthy success with government intervention.
Perhaps the best known examples come from the activities of the Ministry
of International Trade and Industries (MITI) in Japan. It is doubtful whether
the phenomenal success of Japan in many lines of industrial production would
have been possible without the initial promotional efforts of MITI. For exam-
ple, in the 1950s MITI organized, in collaboration with the Japanese industries,
a massive research and development effort aimed at identifying the best areas
for future action. These efforts led to the creation of a technological and
economic base for the future expansion of industries such as optics, electronics
and automobiles. Eventually Japan came to dominate the world market in these
lines of production. This example illustrates that foreign trade transformation
possibilities are not there for everyone to see and to take advantage of.
Sometimes, as in Japan, the state can play a crucial role in shaping the
perception of producers and traders leading to hitherto unforeseen possibili-
ties. Without state initiatives such outcomes might have remained beyond the
reach of agents in a free market economy.
An even more dramatic example of the effects of this kind of intervention
comes from Tanzania in the 1960s (Sabot, 1988). Before Independence in
December 1961, most wage-earners in Tanzania were employed in plantations,
where wage rates and productivity of labor were low. These wage-earners were
migrant workers, who usually returned to their villages after a period of work
in the plantations. The plantation owners repeatedly turned down the sugges-
tion that higher wages would create a permanent labor force with higher
productivity. They argued that the supply curve of labor was backward-bend-
ing and higher wages would make African workers work even less. However,
after Independence, the government decreed a drastic increase in wage pay-
ments in the organized sector of the economy, which led to a three-fold
increase in the wage rate faced by the plantations. This forced the plantation
owners to introduce major changes in their system of management. Between
1961 and 1968, aggregate employment in the sisal industry declined from
129,000 to 42,000, but production increased by about 400 percent, without any
addition to the stock of physical capital. This dramatic demonstration of the
efficiency wage hypothesis was the result of changes forced upon unwilling
entrepreneurs from outside.
Naturally, all the various intervention schemes designed by the govern-
ment of Tanzania did not yield positive results. Neither was the government of
Japan successful with all its grand schemes of economic regulation. For exam-
ple, the New Township Development Scheme of the early '60s, which was to
disperse industrial activities away from the Osaka-Nagoya-Tokyo complex,
became an expensive failure. Whether a particular government in a particular
situation will be able to take the correct course of action is a difficult question,
to which, perhaps, there is no context-free answer.
 Mrinal Datta-Chaudhuri 35

The State and the Polity

In an earlier era Mao Zedong had introduced China's statist development

strategy with the slogan: "Put politics in command." This formulation is
analytically helpful, because it recognizes that the state is a creation of the
polity. The point is obvious in the case of a democratic polity, where the
activities of a government are circumscribed by the preferences of the dominant
interest groups. But even an authoritarian regime can never be indifferent to
the questions of legitimacy and popular support.
This point is perhaps best illustrated by an example from Taiwan in the
early 1970s (Datta-Chaudhuri, 1981b). At that time, Taiwan had had the lion's
share of the lucrative market for bananas in Japan. The production of bananas
was organized in small firms using labor-intensive techniques of production.
Soon it became obvious that for selling a perishable commodity like bananas to
a distant market, large firms (whose production, grading, handling, and pack-
aging were mechanized) had a clear advantage over the traditional methods of
production and distribution. A number of multinational farms went to the
neighboring country, the Philippines, and established giant mechanized banana
plantations, after displacing thousands of small farmers. Taiwan saw this devel-
opment in the Philippines but prevented any attempt at the creation of large
mechanized farms at home, and thereby willingly allowed its market share in
Japan to fall drastically.
The example is especially significant because Taiwan was—and still is—one
of the most aggressively market-oriented economies in the world and it also
had an authoritarian government. Nonetheless, the government of Taiwan did
not allow the logic of free market to operate where the livelihood of a large
number of farming families were at stake. The usual argument that "sooner or
later" the displaced workers would find alternative employment in other
efficient industries was politically unacceptable to the society at large.
While political compulsions are important determinants of state action, it is
not always easy to recognize the true nature of those compulsions. Actions of a
government are never solely dictated by economic considerations, although
economic arguments are often employed to legitimize actions which have
different intents. Outside observers often reach misleading conclusions because
they are unable to see through the strategic behavior of politicians.
For example, the People's Action Party (PAP) of Singapore introduced
repressive measures to control trade union activities with the argument that
they were necessary for attracting foreign investments and for competing
successfully in export markets. But Hong Kong did not repress its labor
movement, nor did it suspend the institution of collective bargaining. This did
not affect Hong Kong's ability either to attract foreign capital or to perform
successfully in export markets. In recent years, South Korea has seen the
emergence of active trade unionism, which is often noisy and sometimes
36 Journal of Economic Perspectives

militant; but it does not seem to have affected the performance of the South
Korean economy adversely. The government of Singapore obviously moved
towards a repressive regime to ensure the political survival of the party in
power, but it sought legitimacy for its action by invoking economic arguments
which had some measure of popular appeal. It, of course, had the unfortunate
by-product of confusing many outside economists.
These matters make political economy a difficult subject. Nonetheless, it is
possible to identify a few broad features of a polity that crucially influence the
relationship between the state and the economy. For example, to explain the
evolution of the successful relationship between the state and the economy in
South Korea, it is important to consider the land reform imposed on that
country (as well as in Japan and Taiwan) from outside after the Second World
War. Land reform destroyed the political power of the landed aristocracy and
helped the emergence of the commercial and industrial middle classes as the
dominant elite in the country. The homogenous social base of the military and
the business elite in the early days of President Park paved the way for a system
("Korea Inc.") where the power of the state was brought to control the
economy through formal as well as informal channels (Jones and Sakong,
1980).
The importance of this phenomenon becomes apparent when one com-
pares the performance of the South Korean economy with that of the Philip-
pines. The two countries have remarkable similarities geographically as well as
in demographic terms. In the early 1960s, per capita incomes in the two
countries were very similar.11 Both countries had close relationships with the
United States in military, political and economic matters. The government of
each country had a strong ideological commitment to capitalism. Park Chung
Hee and Ferdinand Marcos were not dissimilar in their political values and in
their willingness to use repressive measures. Yet, the two economies had very
different records of economic growth. Social scientists do not as yet have the
tool-kit to explain these differences satisfactorily, but it is not difficult to see
how the dominance of the landed aristocracy in the political economy of the
Philippines hindered the creation of a dynamic capitalist economy. The same
factors were also responsible for the Philippines not trying to achieve a greater
measure of distributive justice in the society (Datta-Chaudhuri, 1981a).
In the case of India, the size and the heterogeneity of the country
prevented a single homogeneous group from dominating the polity and the
state. A few dominant classes, fragmented by regional differences, exert collec-
tive control over state machinery.12 Such a coalition had to rest on implicit
understandings regarding the manner in which the state could control and

11
According to the World Bank, per capita GNP at current prices in the Philippines went up from
$210 in 1967 to $590 in 1987. During the same period in South Korea it went up from $240 to
$2690.
12
For an analysis of India's political economy as a bargaining equilibrium of dominant classes, see
Bardhan (1984).
 Market Failure and Government Failure 37

regulate the economy. In India, these understandings can be summarized as

follows:
First, the affluent peasantry, who constituted perhaps the most powerful
group within the Indian coalition, successfully imposed three conditions on
economic policies: land reforms should not be pushed beyond a certain point;
there should be no taxation of agricultural income and wealth; and the state
should maintain high prices for outputs and low prices for major inputs and
thereby maintain a budgetary policy with heavy subsidies.
Second, the big industrialists, the second group in the dominant coalition,
wanted the state to create profitable opportunities for their expansion in the
home market. This meant public sector outlays in social overhead capital,
subsidized intermediate goods produced by the public sector, and protection
from foreign competition.
Third, the working classes and other employees in the organized sector
wanted legal and procedural guarantees ensuring employment security. This
reduced the ability of the industrial organization to make quick adjustments in
production processes and to create an environment for quick learning.
Fourth, the backward regions of the country demanded a mechanism of
investment allocation, whereby new industrial units would be located in those
states.
The Indian industrial organization and the policy environment in which it
operates are the results of these implicit understandings, which support the
equilibrium of group interest in the country's political economy. This is why the
Indian state cannot acquire direct control over a larger fraction of the economy's
investable resources, as is the case in South Korea. For over a decade, succes-
sive governments in New Dehli have tried to reform the existing regulatory
mechanisms, which do not encourage either cost and quality consciousness or
fast learning and quick adjustments. They have not succeeded, because they
could not disturb the old equilibrium in the polity which supports the power of
the state.

Summary and Conclusions

Market failures present serious obstacles to the growth process of a back-

ward economy. Unfortunately, development economists in the 1940s and 1950s
focussed their attention on a rather limited class of market failures; those
associated with investment decisions. In the field of development policy, this led
to a strong emphasis on investment planning with the naive belief that once the
physical capital was installed, the subsequent problems of production and
productivity improvement would automatically be resolved.
Subsequent research and development experiences discovered serious
market failures associated with the operation of installed capacities. The prob-
lems arise from the various facets of the learning process, which is of crucial
38 Journal of Economic Perspectives

importance to a developing economy. Learning occurs at several levels: how to

operate new techniques of production; how to introduce cost-reducing and
quality-improving innovations; how to change the product-mix quickly in
response to a changing environment. The state can play an important role in
helping the economy to acquire those skills. However, in designing an appro-
priate role for the state it is important to remember two things.
First, although the market operates inadequately in many spheres, it
performs an important function in disciplining producers against wasteful use
of resources. Secondly, in a changing world, the required institutional changes
in markets do not always take place automatically. The state can play an
important role in promoting and supporting the right kind of market institu-
tions.
The principal function of a market organization is to institute rewards and
penalities around economic activities. It is important to remember that any
economic system must have such schemes of rewards and penalities to guard
against wasteful use of resources. Therefore, an activist government needs to
strengthen the market institutions so that it can influence the behavior of
economic agents effectively. In those spheres where market signals alone are
not effective guides to desirable action, appropriate non-market institutions are
required to be created. Thus, the market-versus-government dichotomy is a
fake one.
The performance of a market economy depends on the perception of
economic agents regarding the technological and market opportunities avail-
able to them. In some cases, unaided market mechanisms were unable to
realize potential economic gains, because economic agents had failed to per-
ceive those options. There are also instances where the state influenced the
behavior of producers and traders in a positive direction either through
coercive regulations or by cooperative action.
Can a government be relied upon to do the "right" thing and avoid doing
the "wrong" thing? It is impossible to give a context-free answer to this
question. Economists, as outsiders, tend to believe that it is all a matter of
knowing what is right and what is wrong. If that were the case, many tricky
problems would have disappeared a long time ago. A government's policies
reflect the interests of the dominant social groups which control the state.
Changes in the economic policies almost invariably hurt some of these interests,
which makes changes difficult within a gradualist framework. Economic analysis
can be very useful in identifying areas of potential gains and thereby helping to
create new constituencies for change. Such analysis can also identify methods of
adjustment which are politically acceptable.
The important question for developing societies is how to develop a
mutually supportive structure of market and non-market institutions, which is
well-suited to promote economic development. This makes normative develop-
ment economics a difficult art.
 Mrinal Datta-Chaudhuri 39

• I am grateful to János Kornai, Louis Lefeber, Stephen Marglin, Roderick

McFarquhar and Amartya Sen for useful discussions. Pranab Bardhan, Richard
Eckaus, Carl Shapiro, Joseph Stiglitz and Timothy Taylor made valuable comments on
an earlier draft of this paper. I am, of course, responsible for any errors that may remain.

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