MB1102 MANAGERIAL ECONOMICS

UNIT I
Syllabus
The themes of economics – scarcity and efficiency – three fundamental economic problems
– society’s capability – Production possibility frontiers (PPF) – Productive efficiency Vs
economic efficiency – economic growth & stability – Micro economies and Macro
economies – the role of markets and government – Positive Vs negative externalities.

INTRODUCTION
Managerial Economics is economics applied in decision-making. It is a special branch of
economics bridging the gap between the economic theory and managerial practice. Its stress is
on the use of the tools of economic analysis in clarifying problems in organizing and evaluating
information and in comparing alternative courses of action.‖ -W. W. Haynes

Managerial Economics is the integration of economic theory with business practice for
the purpose of facilitating decision-making and forward planning by management. - Spencer &
Siegelman
The purpose of Managerial Economics is to show how economic analysis can be used in
formulating business policies. -Joel Dean

THE THEMES OF ECONOMICS

At the most basic level, economics attempts to explain how and why we make the
purchasing choices we do. Four key economic concepts — scarcity, supply and demand, costs
and benefits, and incentives — can help explain many decisions that humans make.

SCARCITY AND EFFICIENCY

 The principles of economic efficiency are based on the concept that resources are
scarce. Therefore, there are not sufficient resources to ensure that all aspects of an economy
function at their highest capacity at all times.

Def: A situation in which the amount of something available is insufficient to satisfy the desire
for it. There are an unlimited variety of scarcities, however they are all based on two basic
limitations

Scarce time
Scarce spending power
Limitations force each of us to make choices. Economists study choices we make as individuals,
and consequences of those choices. Economists also study more subtle and indirect effects of
individual choice on our society. The problem for society is a scarcity of resources

Scarcity of Labor
Time human beings spend producing goods and services

Scarcity of Capital
Something produced that is long-lasting, and used to make other things that we value
Human capital
Capital stock

Scarcity of land
Physical space on which production occurs, and the natural resources that come with it

Scarcity of entrepreneurship
Ability and willingness to combine the other resources into a productive enterprise

As a society our resources—land, labor, and capital—are insufficient to produce all the goods
and services we might desire. In other words, society faces a scarcity of resources.
CAUSES OF SCARCITY
1. Personal Perspective: your own feelings of what is needed or wanted.
2. Poor Distribution of Resources: not using your resources to their potential.
3. Rapid Increase in Demand: A sudden rush to use resources can cause a shortage.
Ways we deal with Scarcity
1. Doing without something
2. Creating more resources
3. Making better use of our resources

EFFICIENCY
Given unlimited wants, it is important that an economy make the best use of its limited
resources. Def : “The most effective use of society’s resources in satisfying people’s wants and
needs.” The essence of economics is to acknowledge the reality of scarcity in a way which
produces the most efficient use of resources. Assessing the efficiency of firms is a powerful
means of evaluating performance of firms, and the performance of markets and whole
economies.
There are several types of efficiency, including allocative and productive efficiency,
technical efficiency, dynamic efficiency and social efficiency.

Allocative efficiency
Allocative efficiency occurs when consumers pay a market price that reflects the private
marginal cost of production. The condition for allocative efficiency for a firm is to produce an
output where marginal cost, MC, just equals price, P.
This occurs when there is an optimal distribution of goods and services, taking into
account consumer’s preferences.
A more precise definition of allocative efficiency is at an output level where the Price
equals the Marginal Cost (MC) of production. This is because the price that consumers are
willing to pay is equivalent to the marginal utility that they get. Therefore the optimal
distribution is achieved when the marginal utility of the good equals the marginal cost.
 At an output of 40, the marginal cost of the good is Rs. 6, but at this output, consumers
would be willing to pay a price of Rs. 15. The price (which reflects the good’s marginal utility) is
greater than marginal cost – suggesting under-consumption. If output increased and price fell,
society would benefit from enjoying more of the good.

At an output of 110, the marginal cost is Rs. 17, but the price people are willing to pay is
only Rs. 7. At this output, the marginal cost (Rs.17) is much greater than the marginal benefit
(Rs. 7) so there is over-consumption. Society is over-producing this good.
 Allocative efficiency will occur at a price of £11. This is where the marginal cost (MC) =
marginal utility.

Productive efficiency
Productive efficiency occurs when a firm is combining resources in such a way as to
produce a given output at the lowest possible average total cost. Costs will be minimised at the
lowest point on a firm's short run average total cost curve.
Productive efficiency is concerned with producing goods and services with the optimal
combination of inputs to produce maximum output for the minimum cost.

This also means that ATC = MC, because MC always cuts ATC at the lowest point on the ATC
curve.

A firm is said to be productively efficient when it is producing at the lowest point on the short
run average cost curve (this is the point where marginal cost meets average cost).

Productive efficiency is closely related to the concept of technical efficiency. A firm is

technically efficient when it combines the optimal combination of labour and capital to produce a
good. i.e. cannot produce more of a good, without more inputs.

Technical efficiency
 Technical efficiency is the effectiveness with which a given set of inputs is used to
produce an output. A firm is said to be technically efficient if a firm is producing the maximum
output from the minimum quantity of inputs, such as labour, capital, and technology.

Social efficiency
This is the optimal distribution of resources in society, taking into account all external
costs and benefits as well as the internal costs and benefits. Social efficiency occurs at an output
where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).

CENTRAL PROBLEMS OF AN ECONOMY

An economic problem generally means the problem of making choices that occurs
because of the scarcity of resources. It arises because people have unlimited desires but the
means to satisfy that desire is limited. Therefore, satisfying all human needs is difficult with
limited means.

CAUSES OF ECONOMIC PROBLEM

 Scarcity of resources: Resources like labour, land, and capital are insufficient as
compared to the demand. Therefore, the economy cannot provide everything that people
want.

 Unlimited Human Wants: Human beings’ demands and wants are unlimited which
means they will never be satisfied. If a person’s one want is satisfied, they will start
having new desires. People’s wants are unlimited and keep multiplying, therefore, cannot
be satisfied because of limited resources.

 Alternative Uses: Resources being scarce, the same resources are used for different
purposes. and it is therefore essential to make a choice among resources. For instance,
petrol is used in vehicles and is also used for generators, running machines, etc.
Therefore, the economy should now make a choice within the alternative uses.
THREE ECONOMIC PROBLEMS:

(A) What to produce?

 A country cannot produce all goods because it has limited resources.

 It has to make a choice between different goods and services.

 Every economy has to decide what goods and services should be produced.

 Example: If a farmer has a single piece of agricultural land, then he has to make a choice
between two goods, i.e., whether to grow rice or wheat.

 Similarly, our government has to decide where to allocate funds, for the production of
defence goods or consumer goods, and if both, then in what proportion.

(B) How to produce?

 This problem refers to the choice of technique of production. It arises when there is an
availability of more than one way to produce goods and services.

 There are mainly two techniques of production. These are:

 Labour intensive technique(greater use of labour)

 Capital intensive technique(greater use of machines)

 Labour intensive technique promotes employment whereas capital intensive technique

promotes efficiency and growth.

(C) For whom to produce?

 The society cannot satisfy all the wants of all the people. Therefore, it has to decide who
should get how much of the total output of goods and services.

 Society has to make choice of whether luxury goods or normal goods have to be
produced. This distribution or proportion directly relates to the purchasing power of the
economy.
Society’s capability
Social capabilities refer to the capabilities of a society to organize itself for development.

PRODUCTION POSSIBILITY FRONTIERS (PPF)

The Production Possibility Frontier (PPF) is a curve on a graph that illustrates the
possible quantities that can be produced of two products if both depend upon the same finite
resource for their manufacture. The PPF is also referred to as the production possibility curve.
PPF also plays a crucial role in economics. For example, it can demonstrate that a
nation's economy has reached the highest level of efficiency possible.

PPF on a National Scale

Imagine a national economy that can produce only two things: wine and cotton. If points
A, B, and C are plotted on a curve, it represents the economy's most efficient use of resources.

For instance, producing five units of wine and five units of cotton (point B) is just as
attainable as producing three units of wine and seven units of cotton. Point X represents an
inefficient use of resources, while point Y represents a goal that the economy simply cannot
attain with its present levels of resources.

As we can see, for this economy to produce more wine, it must give up some of the
resources it is currently using to produce cotton (point A). If the economy starts producing more
cotton (represented by points B and C), it would need to divert resources from making wine
and, consequently, it will produce less wine than it is producing at point A.

Moreover, by moving production from point A to B, the economy must decrease wine
production by a small amount in comparison to the increase in cotton output. But if the
economy moves from point B to C, wine output will be reduced by about 50%, while the cotton
output only increases by about 75%.
Keep in mind that A, B, and C all represent the most efficient allocation of resources for the
economy. The nation must decide how to achieve the PPF and which combination to use. For
example, if more wine is in demand, the cost of increasing its output is proportional to the cost
of decreasing cotton production. Markets play an important role in telling the economy what the
PPF should look like.

How the Curve Can Change

Consider point X in the figure above. If a country is producing at point X, it means its
resources are not being used efficiently—that is, the country is not producing enough cotton or
wine, given the potential of its resources. On the other hand, point Y, as we mentioned above,
represents an unattainable output level.

The only way for the curve to move outward to point Y is if there were an improvement
in cotton and grape harvesting technology because the available resources—land, labor, and
capital—generally remain constant. As output increased, the PPF curve would be pushed
outwards. A new curve, represented in the figure on which Y would fall, would show the new
optimal allocation of resources.

When the PPF shifts outwards, it implies growth in an economy. When it shifts inwards,
the economy is shrinking due to a failure to allocate resources and optimal production
capability. A shrinking economy could result from a decrease in supplies or a deficiency in
technology.
 Assumptions of the Production Possiblity Frontier

There are four common assumptions in the model:

1. The economy is assumed to have only two goods that represent the market
2. The supply of resources is fixed or constant
3. Technology and techniques remain constant
4. All resources are efficiently and fully used

Key Points

 The Production Possibilities Frontier (PPF) is a graph that shows all the different combinations
of output of two goods that can be produced using available resources and technology. The PPF
captures the concepts of scarcity, choice, and tradeoffs.
 The shape of the PPF depends on whether there are increasing, decreasing, or constant costs.
 Points that lie on the PPF illustrate combinations of output that are productively efficient. We
cannot determine which points are allocatively efficient without knowing preferences.
 The slope of the PPF indicates the opportunity cost of producing one good versus the other good,
and the opportunity cost can be compared to the opportunity costs of another producer to
determine comparative advantage.
Economic efficiency
Economic efficiency implies an economic state in which every resource is optimally
allocated to serve each individual or entity in the best way while minimizing waste and
inefficiency. When an economy is economically efficient, any changes made to assist one entity
would harm another.

Productive efficiency Vs Allocative efficiency

Basis Productive Efficiency Allocative Efficiency

Productive efficiency measures a Allocative efficiency measures

firm’s ability to utilize limited whether supply and distribution
Meaning
resources and produce goods at 100% meet consumer demand and
capacity preference

Focus Production process Distribution process

Making the best use of resources for

Aim Improving supply and distribution
enhancing productivity

The manufacturer needs to produce a

Opportunity smaller number of one product to When a commodity’s supply rises,
Cost produce more units of a second its market demand falls
product

(Actual Output Rate) / (Standard Marginal Benefit (Price) =

Formula
Output Rate) × 100 Marginal Cost

A beverage company produces a high A company produces 100 kgs of

Example level of coffee by utilizing 100% of its coffee, and the demand for coffee
resources is also 100 kgs

ECONOMIC GROWTH & STABILITY

 Economic growth is a long-term expansion of a country’s productive potential. Short
term growth is measured by the annual % change in real national output – this is mainly driven
by the level of aggregate demand (C+I+G+X-M) but is also affected by shifts in SRAS.
Long term growth is shown by the increase in trend or potential GDP and this is
illustrated by an outward shift in a country’s long run aggregate supply curve (LRAS).
China and India are examples of very fast-growing countries. Their annual growth has far
exceeded that for most advanced economies; China has out-paced India although both have
experienced a slowdown in growth over the last couple of years
For nations such as the USA and the UK, “normal growth” is of the order of 2 – 3% per
year – depending on where each economy is in their business (trade) cycle. The Euro Zone
growth rate is similar but keep in mind that this is an average, there are seventeen countries at
present who share the same currency, some have been growing quite quickly and others have
struggled to escape from a deep recession and the persistent risk of a depression.

Key drivers of economic growth

There have been numerous research studies in what determines long term GDP growth
Every country is different, each factor will vary in importance for a country at a given point in
time

Advantages of Economic Growth

1. Higher living standards – A community with a high standard of living typically enjoys a
better quality of life than one at or below the poverty line. These areas have thriving
economies that provide employment opportunities and quality goods or services that satisfy the
desires and needs of the individuals residing in the area.
2. Employment effects - growth stimulates more jobs to help new people as they enter the labour
market.
When people are working, they can also help people in need, pay bills and taxes,
purchase items, and use their skills to promote and benefit the general public. All of these
funds are then constantly circulating through global markets, governments, and businesses
worldwide.

3. Fiscal dividend – sustained GDP growth boosts tax revenues and provides the government
with extra money to improve public services such as education and healthcare. It makes it easier
for a government to reduce the size of a budget deficit

4. Investment - the accelerator effect - rising demand and output encourages investment – this
sustains growth by increasing long run aggregate supply

5. Consumer and business confidence - growth has a positive impact on business profits &
confidence. A stronger economy will help to persuade consumers that the time is right to make
major purchases

6. Growth can also help protect the environment such as low-carbon investment, innovation and
research and development, resulting in more efficient production processes to reduce costs.
Ethical consumerism and corporate social responsibility has become important in recent years.

Disadvantages of economic growth There are economic and social costs of a fast-expanding
economy.
1. Inflation risk: If demand races ahead of aggregate supply the scene is set for rising prices.
Many fast growing developing countries have seen high rates of inflation in recent years, a good
example is India

2. Working hours – sometimes there are fears that a fast-growing economy places increasing
demands on the hours that people work and can upset work-life balance
3. Structural change – although a growing economy will be creating more jobs, it also leads to
structural changes in the pattern of jobs. Some industries will be in decline whilst others will be
expanding. Structural unemployment can rise even though it appears that a country is growing –
the labour force needs to be occupationally mobile.

4. Environmental concerns: These include pollution, overpopulation, waste disposal, climate

change, global warming, the greenhouse effect, etc. Various environment protection programs
are being practised at the individual, organizational and government levels with the aim of
establishing a balance between man and the environment.

5. Fast growth can create negative externalities for example higher levels of noise pollution and
lower air quality arising from air pollution and road congestion

6. Increased consumption of de-merit goods which damages social welfare

7. It can leads to a huge increase in household and industrial waste which again creates external
costs for society

8. Growth that leads to environmental damage may lower the sustainable rate of growth.
Examples include the destruction of rain forests through deforestation, the over-exploitation of
fish stocks and loss of natural habitat and bio-diversity created through the construction of new
roads, hotels, retail malls and industrial estates.

9. Deforestation releases more CO2 into the atmosphere each year than all of the world's planes,
trains and automobiles put together. Globally, an area almost the size of England and Wales is
cut down every year releasing billions of tons of CO2 into the atmosphere.

10. Economic Growth and Inequality : A rise in real GDP can lift millions of people out of
absolute poverty but it can often be accompanied by widening income and wealth inequality in
society that is reflected in an increase in relative poverty.
The reason is that the very uneven distribution of income means that there are people who earn
astounding salaries and wages and the income of the super-rich tends to drive up mean incomes.
For example, In the United States, mean income is almost a third higher than median income,
and the gap is growing.

Microeconomics

Microeconomics is the study of decisions made by people and businesses regarding the
allocation of resources and prices of goods and services. The government decides the regulation
for taxes. Microeconomics focuses on the supply that determines the price level of the economy.

It uses the bottom-up strategy to analyse the economy. In other words, microeconomics tries to
understand human’s choices and allocation of resources. It does not decide what are the changes
taking place in the market, instead, it explains why there are changes happening in the market.

The key role of microeconomics is to examine how a company could maximise its production
and capacity, so that it could lower the prices and compete in its industry. A lot of
microeconomics information can be obtained from the financial statements.

The key factors of microeconomics are as follows:

 Demand, supply, and equilibrium

 Production theory

 Costs of production

 Labour economics

Examples: Individual demand, and price of a product.

Macroeconomics

Macroeconomics is a branch of economics that depicts a substantial picture. It scrutinises

itself with the economy at a massive scale, and several issues of an economy are considered. The
issues confronted by an economy and the headway that it makes are measured and apprehended
as a part and parcel of macroeconomics.
Macroeconomics studies the association between various countries regarding how the policies of
one nation have an upshot on the other. It circumscribes within its scope, analysing the success
and failure of the government strategies.

In macroeconomics, we normally survey the association of the nation’s total manufacture and the
degree of employment with certain features like cost prices, wage rates, rates of interest, profits,
etc., by concentrating on a single imaginary good and what happens to it.

The important concepts covered under macroeconomics are as follows:

1. Capitalist nation
2. Investment expenditure
3. Revenue

Examples: Aggregate demand, and national income.

Differences Between Microeconomics And Macroeconomics

Let us look at some of the points of difference between Microeconomics and Macroeconomics

Microeconomics Macroeconomics

Meaning

Microeconomics is the branch of Economics that Macroeconomics is the branch of Economics that
is related to the study of individual, household deals with the study of the behaviour and
and firm’s behaviour in decision making and performance of the economy in total. The most
allocation of the resources. It comprises markets important factors studied in macroeconomics
of goods and services and deals with economic involve gross domestic product (GDP),
issues. unemployment, inflation and growth rate etc.

Area of study
Microeconomics studies the particular market Macroeconomics studies the whole economy, that
segment of the economy covers several market segments

Deals with

Microeconomics deals with various issues like

Macroeconomics deals with various issues like
demand, supply, factor pricing, product pricing,
national income, distribution, employment,
economic welfare, production, consumption, and
general price level, money, and more.
more.

Business Application

It is applied to internal issues. It is applied to environmental and external issues.

Scope

It covers several issues like demand, supply, It covers several issues like distribution, national
factor pricing, product pricing, economic income, employment, money, general price level,
welfare, production, consumption, and more. and more.

Significance

It is useful in regulating the prices of a It perpetuates firmness in the broad price level,
product alongside the prices of factors of and solves the major issues of the economy like
production (labour, land, entrepreneur, deflation, inflation, rising prices (reflation),
capital, and more) within the economy. unemployment, and poverty as a whole.

Limitations

It is based on impractical presuppositions, It has been scrutinised that the misconception of

 composition’ incorporates, which sometimes
i.e., in microeconomics, it is presumed that
fails to prove accurate because it is feasible that
there is full employment in the community,
what is true for aggregate (comprehensive) may
which is not at all feasible.
not be true for individuals as well.

Positive Vs negative economic externalities.

Externalities
Externalities refers to situations when the effect of production or consumption of goods
and services imposes costs or benefits on others which are not reflected in the prices charged for
the goods and services being provided.
An externality is a cost or benefit of an economic activity experienced by an unrelated
third party. The external cost or benefit is not reflected in the final cost or benefit of a good or
service. Therefore, economists generally view externalities as a serious problem that makes
markets inefficient, leading to market failures. The externalities are the main catalysts that lead
to the tragedy of the commons.

The primary cause of externalities is poorly defined property rights. The ambiguous
ownership of certain things may create a situation when some market agents start to consume or
produce more while the part of the cost or benefit is inherited or received by an unrelated
party. Environmental items, including air, water, and wildlife, are the most common examples of
things with poorly defined property rights.

Types of Externalities

Generally, externalities are categorized as either negative or positive.

1. Negative externality

A negative externality is a negative consequence of an economic activity experienced by an

unrelated third party. The majority of externalities are negative. Some negative externalities,
such as the different kinds of environmental pollution, are especially harmful due to their
significant adverse effects. Negative externalities are divided into production and consumption
externalities.

Examples of negative production externalities include:

 Air pollution: A factory burns fossil fuels to produce goods. The people living in the
nearby area and the workers of the factory suffer from the deteriorating air quality.
 Water pollution: a tanker spills oil, destroying the wildlife in the sea and affecting the
people living in coastal areas.
 Noise pollution: People living near a large airport suffer from high noise levels.

Some examples of negative consumption externalities are:

 Passive smoking: Smoking results in negative effects not only on the health of a smoker
but on the health of other people.
 Traffic congestion: The more people that use cars on roads, the heavier the traffic
congestion becomes.

2. Positive externality

Positive externality is a benefit from an economic activity experienced by an unrelated third

party. Despite the benefits of economic activities that involve positive externalities, the
externality also creates market inefficiencies. Positive externalities can also be distinguished as
production and consumption externalities.

Positive production externalities include:

 Infrastructure development: Building a subway station in a remote neighborhood may

benefit real estate agents who transact properties in the area. Real estate prices would
 likely increase due to better accessibility, and the agents would be able to earn higher
commissions.
 R&D activities: A company that discovers a new technology as a result of research and
development (R&D) activities creates benefits that help society as a whole.

Examples of positive consumption externalities are:

 Individual education: The increased levels of an individual’s education can also raise
economic productivity and reduce unemployment levels.
 Vaccination: Benefits not only the person vaccinated but other people in the community
because the probability of being infected decreases.

Solutions to Externalities
Due to the adverse effect of both negative and positive externalities on market efficiency,
economists and policymakers strive to address the problem. The “internalization” of the
externalities is the process of adopting policies that would limit the effect of the externalities on
unrelated parties. Generally, the internalization is achieved through government intervention.
Possible solutions include the following:

1. Defining property rights

A strict definition of property rights can limit the influence of economic activities on unrelated
parties. However, it is not always a viable option since the ownership of particular things such as
air or water cannot be unambiguously assigned to a particular agent.

2. Taxes

A government may impose taxes on goods or services that create externalities. The taxes would
discourage activities that impose costs on unrelated parties.

3. Subsidies

A government can also provide subsidies to stimulate certain activities. The subsidies are
commonly used to increase the consumption of goods with positive externalities.
https://corporatefinanceinstitute.com/resources/knowledge/economics/externality/

THE ROLE OF MARKETS AND GOVERNMENT

There is an economic role for government to play in a market economy whenever the
benefits of a government policy outweigh its costs. Governments often provide for national
defense, address environmental concerns, define and protect property rights, and attempt to make
markets more competitive.

The classical economists like Adam Smith, J.S. Say and other advocated the doctrine of laissez
faire which means non- intervention of the government in economic matters. Adam Smith
introduced the concept of the invisible hand, which refers to the free functioning of the price
(market) system in the absence of government intervention.

And, in the 19th century, the western capitalist economics achieved spectacular growth by
following the policy of laissez faire. As Paul Samuel- son has put it, “An ideal market economy
is one where all goods and services are voluntarily exchanged for money at market prices.
Such a system squeezes the maximum benefits out a society’s available resources without
government intervention”.

The doctrine of laissez faire, which means ‘leave us alone’ held that government should interfere
as little as possible in economic affairs and leave economic decisions to the interplay of supply
and demand in the market place. However, the great depression of 1929 (which lasted for 4
years) shattered the economies of U.S.A. and other western industrialised countries and forced
them to partially abandon the doctrine of laissez faire.

And, in 1936, J.M. Keynes suggested in his revolutionary book: The General Theory that the
visible hand of the government should replace, at least partly, the invisible hand of the market.
Following Keynesian prescriptions governments in most countries took on a steadily expanding
economic role, regulating monopolies, collecting income taxes and providing social security in
the form of unemployment compensation or pension for the old people.
To quote Samuelson again, “in the real world, no economy actually conforms totally to the
idealised world of the smoothly functioning invisible hand. Rather, every market economy
suffers from imperfections which lead to such ills as excessive pollution, unemployment and
extremes of wealth and poverty”.

For all these reasons, any government anywhere in the world, whether conservative or liberal,
intervenes in economic affairs. In a modern economy like our own, the government has to
perform various roles mainly to correct the flaws (defects) of the market mechanism. The
military, policy, most schools and colleges, health centres and hospitals and highway and bridge
construction are all government activities, research and space exploration require government
funding.

Governments may regulate some businesses (such as banking and insurance), while subsidising
others (such as agriculture and small-scale and cottage industries). And last, but not the least
governments tax their citizens and redistribute the revenues to the poor as also the elderly
(retired) people.

Four Main Functions of Government in a Market Economy:

However, according to Samuelson and other modern economists, governments have four main
functions in a market economy — to increase efficiency, to provide infrastructure, to promote
equity, and to foster macroeconomic stability and growth.

1. Efficiency:
First, the government should attempt to correct market failures like monopoly and excessive
pollution to ensure efficient functioning of the economic system. Externalities (or social costs)
occur when firms or people impose costs or benefits on others outside the marketplace.

2. Infrastructure:
Secondly, the government should provide an integrated infrastructure. Infrastructure (or social
overhead capital) refers to those activities that enhance, directly or indirectly, output levels or
efficiency in production.
Essential elements are systems of transportation, power generation, communication and banking,
educational and health facilities, and a well-ordered government and political structure. Since the
cost of providing these essential services are very high and benefits accrue to numerous diverse
groups, such activities are to be financed by the government.

3. Equity:
Markets do not necessarily produce a distribution of income that is regarded as socially fair or
equitable. As market economy may produce unacceptably high levels of inequality of income
and weather. Government programmes to promote equity use taxes and spending to redistribute
income toward particular groups.

4. Economic Growth or Stability:

Fourthly, governments rely upon taxes, expenditures and monetary regulation to foster
macroeconomic growth and stability to reduce unemployment and inflation while encouraging
economic growth.

Macroeconomic policies for stabilisation and economic growth includes fiscal policies (of taxing
and spending) along with monetary policies (which affect interest rates and credit conditions).
Since the development of macroeconomics in the 1930s governments have succeeded in bringing
inflation and unemployment under control.

Table 1 presents a framework for classifying the functions of government along a continuum,
from activities that will not be undertaken at all without state intervention to activities in which
the state plays an activist role in coordinating markets or redistribution assets.
Countries with low state capability need to focus first on basic functions: the provision of pure
public goods such as property rights, macroeconomic stability, control of infectious diseases,
safe water, roads and protection of the destitute. Recent reforms have emphasised economic
fundamentals. But social and institutional (including legal) fundamentals are equally important to
avoid social disruption and ensure sustained development.

Going beyond these basic services are the intermediate functions, such as management of
externalities (pollution, for example), regulation of monopolies, and the provision of social
insurance (pensions, unemployment benefits).

States with strong capability can take on more-activities functions, dealing with the problem of
missing markets by helping coordination.