Government and Markets in a Well Functioning Economy
by Donald Low and Wu Wei Neng
Last updated 23 July 2026
ETHOS Issue 09, June 2011
The financial crisis in 2007–2009 prompted a major rethink of the relationship between the state and markets. Dispelling the myth that competitive markets and self-interested individuals alone are sufficient to ensure efficient outcomes or stable economies, the crisis emphatically demonstrated how unregulated, unfettered markets can fail in ways that undermine even the most advanced economies.
One key lesson from the crisis is that markets often need proper government supervision and regulation to function efficiently. This understanding becomes all the more important as markets become increasingly complex and sophisticated – not just in finance, but also in areas as diverse as healthcare and energy.
STATE AND MARKETS: A BRIEF HISTORY
The evolution of economic thought in the past 200 years has profoundly influenced our notions about the right balance between states and markets. In the 18th and early 19th centuries, the writings of Adam Smith, David Ricardo and others attributed economic growth to the operation of the “invisible hand” of markets. Relying only on prices to allocate resources and ration demand, markets ensured that the interactions between a multitude of agents – each making economic decisions based only on his self-interest – resulted in outcomes more efficient than what central planners can achieve. Markets benefited society at large, with no requirement for active state intervention beyond the provision of a few public goods, such as law and order.
One key lesson from the crisis is that markets often need proper government supervision and regulation to function efficiently.
This laissez faire thinking reigned unchallenged throughout the late 19th and early 20th centuries, until the Great Depression. British economist John Maynard Keynes (1883–1946) argued that markets were inherently uncertain, and if left on their own, could self-depress rather than self-correct. Government intervention was necessary to boost aggregate demand during periods of high unemployment. This “Keynesian Consensus” recommending activist economic policies eventually came to shape the policies of Western governments from the 1950s to 1970s. It was premised on the ability of governments to manage aggregate demand and maintain full employment without causing inflation.
But the consensus began to fray almost as soon it achieved the heights of intellectual dominance in the West. Friedrich Hayek (1899–1992) and Milton Friedman (1912–2006), among others, believed that the government’s ability to affect real outcomes was transient at best and harmful at worst. They argued that the costs of government failure often outweighed those of market failure, and that the state’s clumsy interventions in the market – by depriving people of choice and responsibility – could do more harm than good. The experience of stagflation (the combination of inflation with high unemployment) in the 1970s also raised serious doubts about the Keynesian proposition that activist government policies were both possible and desirable. These ideas greatly influenced economic reforms in the Thatcher and Reagan administrations and led to the privatisation of nationalised industries, tax reductions to reduce the burden on businesses, curbs on union power, deregulation and the promotion of competition, and more broadly, a reduced role for government in the economy throughout the 1980s and 1990s.
In the 1990s and early 2000s, a greater awareness of the social and economic costs of unrestrained capitalism and of the inability of unfettered markets to deal with externalities and market failures led to more nuanced views on the appropriate state-market relationship. Economists such as Amartya Sen, Joseph Stiglitz, Paul Krugman and Dani Rodrik emphasised the critical interdependence of governments and markets, in which one could not function properly without the other.
While acknowledging the indispensable role of markets and prices to signal scarcity and allocate resources between competing claims, these economists and others also emphasise situations in which the unregulated interactions between economic agents can produce outcomes that are less than socially desirable. The existence of “market failures” provides a prima facie case for the Government to improve outcomes through specific interventions. Market failures can generally be classified into four categories:
Informational failures occur when people or firms do not have sufficient information or are uncertain about future costs and benefits, and consequently cannot form stable or rational expectations about the future. In other instances of informational failure, one part of the market (e.g. the seller) has more information than another (the buyer), leading to outcomes where the party that is information disadvantaged is unable to make decisions that are in his own interests.
Missing markets occur because prices do not always reflect the full costs or benefits to society. When markets fail to price in the external or spillover effects of one’s actions, it can lead to outcomes that are privately optimal but socially sub-optimal. Unregulated markets will tend to over-produce and over-consume goods with negative externalities (e.g. air or noise pollution); they will also tend to under produce goods with positive externalities (e.g. public health). There will also be under-provision of public goods such as national defence, which are nonexcludable and non-rival, and hence almost impossible for commercial producers to charge users for.
Coordination failures occur when actions that are rational for an individual are irrational collectively. For instance, it is rational for individual fishermen to catch as many fish as possible, but if all fishermen did this, the fishery would collapse. This is known as the “Tragedy of the Commons”. These coordination failures are the primary reason why challenges such as global warming are so difficult to resolve.
Monopoly power occurs because barriers to entry are significant enough to deter new firms from entering the market, hence entrenching a dominant position for the incumbent firm. In many occasions, this dominant position is preserved through anti-competitive practices such as predatory pricing and dumping. Without competitive pressure, the incumbent firm has far fewer incentives to keep prices low, provide an adequate supply and improve its products.
HOW GOVERNMENT CAN HELP MARKETS FUNCTION BETTER
The fact that market economies mostly function well might appear to be a vindication of the effectiveness of unfettered markets and Adam Smith’s “invisible hand”. Hundreds of thousands of highly differentiated products and services are readily available to consumers. To serve these consumers, firms, banks and other financial intermediaries are linked through a highly developed and sophisticated system of investment, production and distribution chains. This well-oiled system seems to run on autopilot in response to the forces of demand and supply, mediated only through prices. There is no central intelligence – neither is there a need for one – to guide or coordinate the activities of market economies.
What is often under-appreciated, however, is that well-functioning markets are embedded in a larger environment that creates the necessary conditions for their effective operation. Markets do not function as well without a certain degree of macroeconomic stability, trust and confidence that contracts will be honoured, measures to curb monopoly power, and wide acceptance of markets. These preconditions for markets to work well are achieved through establishing the right institutional conditions.
Institutions are the rules that govern and shape human interactions; such rules underpin all functioning societies and economies. Four categories of institutions, based on the work of economist Dani Rodrik, are recognisable in the most advanced economies:
Market-enabling institutions, such as the rule of law, secure property rights and independent judiciaries, provide economic agents with the tools for conflict management and for the recognition of rights and responsibilities. They enable dispute resolution and the enactment of long-term contracts. Without such institutions, the economy would be little more than a bazaar.
Market-regulating institutions, such as competition commissions, provide a check on the abuse of market power, improve the extent to which market prices accurately reflect social costs and benefits (for instance, through the taxation of goods which produce negative externalities), and ensure that there is sufficient competition to prevent firms from abusing whatever monopoly power they may have.
Market-stabilising institutions, such as fiscal rules and independent central banks, reduce volatility in markets and the economy. The central bank also serves as a lender of last resort to prevent self-fulfilling banking crises due to panics. In a similar vein, fiscal rules that limit the Government’s ability to spend contribute to macroeconomic stability.
Market-legitimising institutions are those that enhance and maintain public support for market economies. They redistribute income, provide social insurance, and are an important source of social stability. These institutions are conducive to long-term development because they help to give citizens a stake in economic development.
PRINCIPLES FOR EFFECTIVE GOVERNMENT INTERVENTION
Institutions matter because markets are embedded in a larger social and political environment; good institutions help set the rules and norms which are conducive for economic development. However, policymakers must ensure that these institutions and interventions do not “squeeze out” the effective operation of markets. Very often, the central question for governments is not state versus markets, but how governments should intervene in markets.
Based on the relative strengths of government institutions and markets, it is possible to establish a set of principles that policymakers could consider when designing or taking into account interventions:
Do no harm. Governments can make mistakes and should know its limits. There are some things that states must provide – e.g. secure property rights and national defence. However, it is useful to remember the cautionary note by Financial Times commentator and economist Martin Wolf that “the mechanism of the state is at least as defective as that of the market. Throughout history, it has been far more so.”1 Governments should set themselves a high burden of proof that their interventions are more likely than not to improve market outcomes.
Mimic markets, and ensure the right incentives. The Singapore Government generally prefers to support and augment the proper functioning of markets, and to use price-based interventions (e.g. an externality charge) rather than through command-and-control measures such as outright prohibitions. By working through markets and prices, the Government maintains incentives for people to economise on scarce resources and to take into account the externalities they are creating.
Intervene surgically. Effective interventions target the market failure specifically, and minimise “collateral damage” from unintended impacts. The WIS scheme deals with widening income inequality by raising the wages of low-wage workers in a “surgical”, targeted manner. These limited interventions are more efficient than those that distort relative prices (such as measures to depress the prices of certain goods) or those that require large-scale government involvement to monitor and enforce.
Be prepared to rethink the case for government interventions. Finally, governments should take a pragmatic, adaptive and learning-by-doing approach when determining the right state-market balance. Technologies and market conditions change. Areas that required government intervention in the past may no longer require it, or may require it in a different form. The Singapore Government’s approach has generally been a non-ideological one. In many areas of public policy, its role has evolved significantly. For instance, in the areas of electricity generation and telecommunications, the state no longer owns and operates these utilities but performs a regulatory role.
Market-Compatible Interventions: Examples from Singapore
The most successful examples of government interventions are those which harness the strengths of markets and the price system, along with specific and targeted government action. Interventions which go with the grain of market incentives, which make use of price signals, and which augment and complement markets instead of replacing them tend to work much better than interventions based on coercion or command.
Industrial Policy: Intervening to Develop New Capabilities
In Singapore, activist industrial policies have been judiciously used to increase the technological sophistication and value add of the economy, and to accelerate the rate of technology transfer from developed economies. Rather than being a mechanism for picking winners, as is the case in many countries,1 industrial policy is seen as a way of developing new capabilities to generate and sustain economic growth. Nonetheless, the central informational problem with industrial policy remains: how do we know we are making the right bets?
A good illustration of Singapore’s approach is the Cluster Development Fund (CDF), established in 1993 under the Economic Development Board (EDB) to address gaps in industry clusters, extend partnerships with MNCs, and support promising local enterprises. The CDF operates on at least two market principles. The first is that the investments made using the CDF are expected to be commercially viable. Investments are required to generate a minimum target return. Second, projects are undertaken on a co-investment basis with the private sector, the idea being that the project is more likely to be commercially worthwhile if the private sector is willing to commit resources to it. CDF investments have helped to kick-start a number of new growth industries in Singapore such as wafer fabrication and pharmaceuticals.
Seen in this light, industrial policy in Singapore does not crowd out the private sector. Neither does it replace the disciplining force of markets or shelter firms from competition. Instead, it is a way of developing new capabilities more quickly than the economy would on its own. Just as importantly, industrial policy helps to address the Missing Market problems (such as firms’ inability to capture the full benefits from early R&D and training investments due to spillovers and poaching of trained staff by competitors) that may prevent the emergence of a new industry.
Vehicle Ownership and Usage: Intervening to Manage Externalities
Negative externalities created by vehicles – congestion and pollution – can impose a significant economic cost on society which individual car owners do not take into account in their private decision making. Consequently, land-scarce Singapore employs extensive measures to curb the ownership and usage of private vehicles, adhering strictly to the market principle of “pricing the externality”. This is most apparent in the widespread use of congestion charging \[known as Electronic Road Pricing (ERP) in Singapore\]. Under the ERP system, motorists are charged each time they drive past an ERP gantry during operational hours, with prices adjusted based on traffic conditions.2 By pricing the externalities that motorists cause, the ERP system helps to keep traffic congestion at manageable levels.
Similarly in managing vehicle ownership, Singapore also encourages vehicle owners to take into account the wider social costs they create. In addition to the conventional tool of registration fees (in effect, a Pigouvian tax), new vehicle buyers must also obtain a 10-year permit (called a “Certificate of Entitlement”) to own their vehicles. The number of permits that are available is fixed by the Government and the price of the permit is determined by auction. By setting vehicle quotas and pricing them through a bidding system (somewhat akin to a cap-and-trade system), the Government effectively appropriates the rent that would otherwise have become profits for car dealers.
Healthcare and Retirement Savings: Intervening to Support Individual Responsibility
In many countries, healthcare and pensions are financed heavily by taxes. As populations age, these pay-as-you-go systems can run into financing difficulties. Health and pension systems that are mainly financed by taxes also face problems of moral hazard or overconsumption: consumers are less likely to be prudent in their healthcare decisions if they do not bear a significant part of the costs. Workers have less incentive to save for their retirement if they are guaranteed a certain level of pension benefits in their old age.
To deal with these issues, Singapore’s health and pension systems follow the market-based principle of individual responsibility. Healthcare in Singapore is never free: patient co-payment discourages over-consumption and sharpens incentives for Singaporeans to look after their own health and be prudent in their healthcare choices. To help Singaporeans meet their healthcare bills, a compulsory medical savings scheme – Medisave – requires Singapore workers to put aside a portion of their wage incomes in a personal account earmarked for hospitalisation (and some other medical) costs. Medisave preserves the individual’s freedom of choice of healthcare provider and hospital ward type. In short, individual responsibility is coupled with individual choice.
To support individual responsibility in retirement savings, Singapore operates a mandatory save-as-you-earn social security system known as the Central Provident Fund (CPF). Under the CPF system, all employees in Singapore are required to contribute a certain percentage of their incomes. Employers are also required to contribute to the individual savings accounts of their employees. Significantly, the CPF system is fully-funded; other than paying interest on accounts and occasional CPF top-ups, the Government does not incur any cost in running the CPF system. This discourages any notion that retirement benefits are public goods provided by the state, and helps to ensure that population ageing does not create an ever-larger fiscal liability for the state.
CHART 1: WORKFARE INCOME SUPPLEMENT: MAKING WORK PAY
Workfare: Intervening to Support Low-Income Singaporeans
While the CPF system helps to promote self-reliance and individual responsibility, it is clearly not intended to be a tool for redistribution. How then does Singapore deal with growing income inequality? Besides ensuring good education opportunities for all Singaporeans, the recently-introduced Workfare Income Supplement (WIS)3 operates through the price system, i.e. wages. Under the WIS, older workers who are earning low wages are provided a wage supplement that can be as high as 20% of their income.
Tying government transfers to work circumvents the incentive problem associated with traditional cash transfers to the unemployed, while also providing the Government an incentive-compatible way of redistributing incomes. Chart 1 highlights the key differences between Singapore’s workfare system and traditional laissez faire or welfare state approaches.
Notes
At its worst, industrial policy can become a vehicle for corruption and rent-seeking if not properly implemented.
Traffic conditions are benchmarked to vehicular speeds within the optimal ranges of 45-60 km/h for expressways and 20-30 km/h for arterial roads.
The WIS was introduced in 2007 and enhanced in 2010 in response to increasing income inequality, which in turn was attributed to skill-based technical change and low-wage competition from abroad.
ABOUT THE AUTHOR
Donald Low was formerly Head of the Centre for Public Economics and is currently Vice President of the Economics Society of Singapore.
Wu Wei Neng is Deputy Head and Senior Faculty Member at the Centre for Public Economics (wu\_wei\_neng@cscollege.gov.sg), Civil Service College.
NOTES
Wolf, Martin, Why Globalization Works (USA: Yale University Press, 2004)