The Role of Government

The purpose of neoclassical theory is to reveal how a market economy would behave under conditions of perfect competition. A government is allowed to exist, but only under strictly limited conditions. It has the responsibility of maintaining the legal framework for a competitive economy, and of providing certain public goods, such as defence, whose optimum output cannot be achieved by purely market transactions. Where there are deviations from perfect competition, it is often suggested that governments should use taxes, subsidies or, in the case of public enterprises, their executive power to imitate the perfect market by making price equal to marginal cost. Most people would argue that the government should also provide, or at least finance, free schooling, and some health services. In the richer countries government expenditure now normally exceeds one-third of GDP, and in most of western Europe it is in the region of one-half. Governments also intervene in the private sector in a wide variety of ways, for example, by imposing minimum wages and other rules affecting the employment of labour, and by obliging employers to contribute towards accident insurance and social security or private pension funds. In addition, taxes are levied on almost every type of transaction.