Market failure and state failure: What is the way forward?

A market failure takes place when it fails to allocate resources efficiently, whereas a state failure occurs when the state intervention is unsuccessful while correcting the market failure. Many researches and studies have been undertaking by economists and aid agencies to discover the causes and propose the solutions. I put some of these findings to support my argumentation.

Khan (2002) argues that a state failure arises when a state fails to do things that could have improved economic performance and an error of commission when the state does things which worsen economic performance. To further justification, Khan proposes that state failure in developing countries contributes to under-performance economy (noted by the decline in GDP per capita level and the rises of inflation rate) and poverty as a failure in service-delivery provision. Food shortage, even famine, may follow, not to mention high rates of unemployment and growing inequality which leads to social conflicts, such as crime. To raise the causes, Khan argues that the failure relates to an inter-dependent constellation failure including corruption and rent-seeking, distortions in markets and the absence of democracy. Another failure relates to ‘social transformation’ context whereby traditional production systems collapse and a capitalist economy begin to emerge. The failure derives from a lack of institutional and incapability of institutional capacities with pre-existing distributions of power.

So that, in case of both market and state failure takes place, such conditions will create uncertainty, lack of trust and lack of information which make it difficult to achieve efficient outcome in short term between economic actors. Therefore, the way forward to manage such failure conditions is predominantly beginning by improving policy coordination between bureaucrats and politicians. The reforms in government institutions and a wider political system lead to a more efficient outcome, as well as prevention from particularly ‘lobbying’ behaviour in politics. The reform should also be emphasised the necessity of enforcing moral hazard within governance to its constituents.

Lastly, public-private partnership in any kind of forms is essential to secure the economic, social, and community development. This partnership should derive from the same understanding and trustworthy among economic actors. In addition, government is obliged to be more transparent and giving more opportunity in access information. Accountability is another way of translating transparency and trustworthy. Last, but not least, the politicians’ commitment to participate in the partnership can strengthen the sustainability of partnership.

State Failure in Social Contract and Public Choice Theory

‘Social contract’ theory of a state explains the origin and purpose of relation within the government and its people (Wiki Encyclopedia). The essence of the theory is proposed by Jean-Jacques Rousseau which gave enlightens of an assumption to the terms of agreement and mutual understanding between the government and people. To give a greater meaning, social contract relates to the government services to fulfil the interest of people (service-based delivery) and enforce the contract. Neo-classical economists suggested ‘social contract’ as the argument for government intervention in market failure.

In contrast, the ‘public choice’ theory, which most advocated by James Buchanan, involves the interaction of the voters, the politicians, and the bureaucracy in decision-making. Therefore, this theory is likely to be the argument against government intervention by giving proposition that a market failure is not necessarily a sufficient condition to establish intervention (Demsetz). By implementing integral interaction, it will lead to a better quality of policy exposures which is aimed to support the well-functioning markets.

To address as to whether a state failure can be explained from these two standpoints, it is worth noting that potential state failure may arrive from both of theories. This proposal arrives from an understanding that bureaucrats and politicians usually face incentives and own interest that tend to lead them producing inefficient income. Public, as voters, are also seeking for their own interest. So long as social contract or public choice theory is supported by a strong commitment from each economic actor, I agree that the state failure is oddly inevitable. Therefore, the government and politicians should have intentions to strengthen their institutional capacity.

Measuring Effectiveness and Efficiency of Resources Use by Countries

How can countries use their wealth more effectively benefit their people?

To further clarify this matter, the United Nations Development Program (UNDP) establised some indicators to measure economic development of countries which is aiming to achieve the most possible output with available resources. This particularly applies against the background that the effective use of resources can be a means of countries' endeavours to transform assets into income. The income is latter giving more benefit to people.

Gross Domestic Product (GDP) per capita is generally regarded as the relevant reference value to measure the level of economic activity of countries. This asumption is based on the interpretation that GDP per capita reflects the standard of living and, in particular, is accessible to measure the total value for final use of output produced by an economic activity. Beside the general suitability of the GDP per capita, it is questionable as to whether and to which content this value reflects the success of development achieved by a country.

To address this issue, the UNDP establised the Human Development Index (HDI) which attempts to analyze a country's socio-economic development comprehensively. In this context, HDI comprises a composite index to link the GDP per capita with the other basic provision of human developments : health and education. Therefore HDI is able to translate a country's benefits of economic growth and development into quality of life for its people.

To make a clear understanding about the difference between GDP per capita and HDI, let us use the example from Indonesia. Indonesia is ranked as a medium level of human development with 0,697 in value (data from HDI 2005) and amount of GDP is US$ 3,361 per capita. It is also derived from the UNDP data that HDI rank is higher than GDP per capita (Indonesia's position in HDI is 110, while in GDP per capita, the rank is 115). With this regard, it is seen that Indonesia has paid much more attention to human development, since the country has tranformed its wealth to benefit its people. An evidence can be given here that the government was intended to allocate at least 20% of its budget to education. It is parallel with the 9-years policy undertaken by the Government which covers the level of primary study up to junior high school. Also, this is aimed to reduce literacy and building human capacity for the long turn. From this standpoint, it might lead us to justification on which the negative difference in the rank on GDP per capita rank and HDI rank somewhat brings different meaning.

An emphasis can be given that the levels of human development can only be reflected from HDI. GDP, which is in a broader sense, measures an overall activity of residents and non-residents that can be generalised as a country's performance. Hence, considering basic human development provisions as one of the area of analysis will lead to a better understanding to indicate the level of effectiveness and efficiency of resources used by countries.

HDI is not a perfect indicator, though. The next question that cross in my mind, is it apply to all of the countries of the world? Is it fair to calculate the same indicator and level of human development between people in developed countries and less-developed countries?