Market system is an institutional arrangement that has persisted and evolved over the past few hundred years because it has contributed greatly to our economic well-being.
It is not perfect, however, and in some situations, our economic well-being can be raised by regulating it or even by side-stepping it altogether. Failure of market is the most important reason behind ‘making of’ an economic policy.
Economic literature says that competitive markets generate a Pareto optimal solution and an economy that reaches a Pareto optimal solution is commonly said to be efficient.
Pareto optimal solution is based on certain assumptions. If one or more of these assumptions does not hold good, the market system does not give rise to an efficient outcome. These inefficient outcomes are called ‘market failures’.
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Choices through time, under-provision of public goods, presence of externalities, existence of common property resources, imperfect competition, asymmetric information, etc., are some of the well-documented reasons for ‘market failures’. These need some sort of Government intervention in the form of ‘economic policies and programmes’.
Further, even if under Pareto optimal solution resources are efficiently allocated, the distribution may not be ‘equitable one’. State through participation in the production activities can give a direction to the resource allocation in more efficient manner in the larger public interest.
It can directly own and manage various public utility services. Competition is wasteful in such industries, and, hence, these can be best entrusted to the state.
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The state itself can undertake the production and distribution of public goods meant by collective consumption. Production of public goods is necessary not only for itself but also for generating new opportunities to secure the goal of full employment.
The state may engage itself in production of such services that are beneficial but which do not attract private enterprise either because they are too risky or because the rate of return on capital employed is too low. There are certain goods of strategic importance that cannot be left in the hands of the state. The state can also act as a countervailing power to private monopolies.
The state may: (i) prevent consumption of noxious products, and (ii) protect the consumers against fraudulent practices. Further, if certain well- specified conditions are met, the Government can shift the economy from one Pareto optimal solution to another by redistributing purchasing power and then allowing people to trade in competitive markets. The need for ‘redistribution that takes the economy to any desired Pareto optimal solution’ underlines the need of economic policy.
Moreover, India at the time of independence was socially and economically backward. In order to solve these problems, the framers of the Constitution provided certain Directive Principles.
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Under ‘directive principles’, it is the duty of the state to ensure to all its citizens the right to an adequate means of livelihood; to ensure a fair distribution of the material resources of the country for the common good; and to distribute the wealth in such a way that the wealth is not concentrated in the hands of a few people. Alf such constitutional obligations can be fulfilled by a sound economic policy.