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State, Market and Institutions: Changing Roles and Relationships in Economic Development Since 1950

Mohan Kumar reviews the work of leading Development Economists to understand the role of the market and the state and how the evolution of the field of Development Economics has contributed to our understanding of these institutions.

[Mohan Kumar is pursuing his Masters in Diplomacy, Law and Business from Jindal Global University, Haryana]


The emergence of capitalism in the eighteenth century after the Industrial Revolution has drastically altered the roles of the state and the market. But the roles of market and the state were defined differently in different countries. The end of the Second World War paved the way for the end of colonialism and the emergence of newly independent countries. It also marked the beginning of interest among scholars and policymakers to study the development process in these countries. This led to the rise of Development economics as a separate discipline in the 1940s and 1950s. Since the evolution of development economics as a discipline, the understanding on the nature and role of market, State and institutions has undergone a metamorphosis.

Development from 1950s to 1970s

In the post-colonial era, most underdeveloped countries adopted development strategies which were different from that followed during the colonial period dominated by free trade. Policy-making in developing countries after the Second World War until the early 1980s was dominated by protectionism and interventionism. Industrialization was considered as the major driver for the growth of economy. During the initial period after independence, the State had a larger role to play in industrialization in developing countries. State interventionism was considered as a necessity to develop the nascent modern indigenous industries because market was perceived as insufficient to meet the aspirations of those countries. These countries also followed the policy of Import Substitution Industrialisation (ISI), particularly in consumer goods. These policies included restrictive licensing systems and high protective tariffs.

The major policy objective of newly independent countries in 1950s was economic growth which was represented by GNP growth. It was believed that economic growth would fulfill other social and developmental objectives. The important theories that dominated the development economics during the 1950s were ‘Big Push’ (Rosenstein-Rodan, 1943), Balanced Growth (Nurske, 1953), ‘Take-off into sustained growth’ (Rostow, 1956), and Critical Minimum Effort theory (Leibenstein, 1957).[1]

During the 1970s, the scope of the development objective got widened. Other objectives along with GNP growth were employment, income distribution and poverty alleviation. The implementation of poverty alleviation programmes also needed a strong state intervention.

Neo-liberalism and the importance of institutions (1980s)

Since the 1980s, the rise of neo-liberalism emphasized on laissez faire policies, free trade and small government. The economic crises in most developing countries in the late 1970s showed the limitations of interventionism and protectionism. As a result most developing countries embraced policy reforms in a neo-liberal direction. The development strategy of the 1980s included outward orientation, reliance on markets and a minimization of the role of government.

New institutional economics (NIE) also became prominent during the 1980s. NIE advocated the establishment of proper institutions to meet the development objectives. NIE attempts to extend economics by focusing on social and legal norms and rules that underlie economic activity. Institutions are the ‘rules of the game’ in a society. It includes both formal rules and informal constraints. Some of the aspects of NIE include property rights, transaction costs, social norms, ideological values, asymmetric information and others.

The developing countries during the 1980s were strongly influenced by happenings in the developed world. The developed world was dominated by the policies of Reagan and Thatcher administration. These policies encouraged to rely on operation of market forces and advocated minimal role for government.

State, market and institutions in the era of globalization (since 1990s)

In the first half of the 1990s, a need was felt for fundamental institutional changes to successfully implement the adjustment strategy followed by developing countries. The most fundamental issue that was debated during the 1990s was the appropriate roles of the State and the market in development. A related issue was to identify the set of institutions conducive to the economic and social development. The institutions and policies followed by the East Asian countries that gave rise to East Asian miracle were considered as the best model to follow. But in the second half of the 1990s, East and South East Asian countries were affected by the Asian financial crisis. This led to the questioning by some critics of policies followed by those countries which relied on government intervention for industrial growth.

The neo-institutional and public choice schools have clarified the role of state in development. The state should actively involve in development by providing a macroeconomic and micro-economic framework conducive to efficient economic activity, by providing the institutional infrastructure that encourages long term investment and by ensuring the delivery of basic education, healthcare and infrastructure.

The World Bank Report in 1993 on East Asian miracle identified the following success elements of East Asian countries. They were sound macroeconomic foundations and stable institutions, an outward orientation, reliance on markets and high investment in building human capital. The East Asian miracle provided an example for the importance of sound institutions to a sustainable growth process. The absence of sound institutions in sub-Saharan Africa was considered as the reason for the low growth of these countries.

The Asian financial crisis led to the questioning of the Washington consensus which advocated trade liberalization and financial deregulation. The crisis also triggered a re-examination of the role of government in protecting the economy from major external shocks. It provided a strong case for government intervention in strengthening the financial institutions and the provision of minimum set of rules and regulations.

 The objectives and definition of development have been further broadened in the 2000s. Human development became the ultimate goal of this decade and sustainable development became a part of it. The policy objectives for human development have been framed within the context of globalization. Human development included many aspects such as education, health, housing and others.

The new political economy of development approach dominant during the 2000s relies extensively on the role of institutions. The quality of institutions determines the development of the country. So the developing countries concentrated on establishing quality institutions.

Review of Development Literature

Ha-Joon Chang’s view on the state , market and institutions[2]

Ha-Joon Chang provides a critical review of the neo-liberal view on the understanding of the state, market and institutions. Instead he advocates an alternative approach known as institutionalist political economy approach to overcome the limitations of neo-liberal approach.

Chang argues for a strong case for State intervention in economic growth with the development of appropriate institutions. He explains that all the developed countries had also used measures of protectionism and interventionism in their early stages of development. He also admits that there existed some important limits to the scope of state intervention for institutional reasons. He explains that the scope of state intervention started broadening towards the end of the 19th century as a result of the failures of laissez faire capitalism.

The spectacular failure of advanced capitalism since the Great Depression made the advanced capitalist economies invest in building national and international institutions in order to soften the business cycles[3]. The failure of laissez faire capitalism in the colonies naturally convinced the post-colonial leaders that their states needed to take an active role after independence.

Chang also criticizes the neo-liberal portrayal of the interventionist period of the third quarter of the 20th century as a period of stagnation. Instead he considers this period as the real ‘golden age of capitalism’. He shows that both the developed and developing countries grew at 3% p.a. in per capita terms during the period of interventionism in 1960s and 1970s compared to the slower per capita income growth during the neo-liberal age of 1980s and 1990s.

The institutionalist political economy approach advocated by Chang establishes the relations of the institutions with the market and the state. The institutions here refers to laws, rules and regulations and also the informal norms. The international political economy (IPE) framework emphasizes that markets need a complex set of formal and informal institutions in their definition and operation. All markets are based on institutions that regulate the participants of the market. There are institutions which determine the legitimate objects of market exchange that help in prohibiting the illegal activities. There are institutions that clearly define the rights and obligations of each agent in each distinct areas. Thus emphasizing the institutional nature of the market shows that markets are political constructs which stresses the importance of political economy.

Chang shows that the institutions also play a major role in shaping the behavior of the agents of the state which he calls it as the ‘constitutive role of institutions’. IPE considers that the motivations of the agents are shaped by the institutions surrounding the agents. This is different from the New Institutional Economics (NIE) which considers institutions as being shaped by the behavior of individuals. But IPE differs from NIE in that it postulates a two-way causation between individuals and institutions, rather than a one-way causation from individuals to institutions.

Chang also criticizes the neo-liberal view of de-politicisation of market. Instead IPE treats politics as an integral part of the construction and operation of market since politics itself is an institutionally structured process. Thus Chang’s major contribution is his application of the institutionalist political economy approach in understanding the nature and role of market and the state. Chang also provides great emphasis on the role of institutions in the functioning of both the market and the State.

Deepak Nayyar’s view on State and market during the era of globalization[4]

Globalisation is a process of increasing integration into the world economy. Globalisation has reduced the economic autonomy of the State and seeks to harmonise not only policy regimes but also institutions around the world. Nayyar advocates for a strategic role for the State not only in the sphere of domestic economic policies but also in the arena of economic and political interaction with the outside world.

Nayyar specifies certain roles for the State in the national context. The State must create the necessary physical and social infrastructure for economic development. The State should also establish institutions that would regulate the functioning of market. The State should also ensure prudent macro-management of the economy. The State intervention is also important in terms of human development through the establishment of proper institutions.

The State also has an important role to play in the international context. The States must endeavour to influence the rules of the game to ensure an equitable outcome. It should also ensure equal representation to all the countries in the international trading system especially the WTO. It should also work for the establishment of a democratic international financial architecture.

The government, as mentioned by Nayyar, should seek to develop mechanisms and policies to ensure that the benefits of development are equitably shared. It requires the creation of institutions to mediate between economic and social development. The role of Government is crucial as markets tend to widen disparities between people and regions. Nayyar also advocates for the strengthening of safety nets such as anti-poverty programmes and social security.

Nayyar accepts that both market failure and government failure are part of an economy. So he emphasizes on introducing corrective strategies against both market failure and government failure. He argues that institutions, markets and Governments could provide mutual checks and balances vis-à-vis each other.

Thus Nayyar emphasizes the importance of the role of State in the process of development in the context of globalization where the economy is dominated by the market. He also emphasizes on the establishment of institutions that would clearly define the role of both the market and the State.

Pranab Bardhan’s view on institutions[5]

Institutions can be defined as the rules of structured social interaction. In the context of economic development the focus is on those rules that act as a substitute for missing market.

Bardhan explains about the persistence of dysfunctional institutions and questions the society of not discarding the inefficient institutions. Discarding those institutions would mean the loss of power by some dominant political and social groups. Thus these powerful groups resist the bringing in of new institutions that will reduce their future political power. Thus the persistence of dysfunctional institutions over a long period of time is considered by Bardhan as the central issue of development economics. The existence of these institutions is mainly because of the existence of inequality in society.

Dani Rodrik’s emphasis on quality of institutions[6]

Rodrik emphasizes on the quality of institutions based on cross country narratives. He found that institutions that provide dependable property rights, manage conflict, maintain law and order, and align economic incentives with social costs and benefits are the foundation of long-term growth. He argues that growth had been difficult to achieve on a sustained basis in the absence of good public institutions. He provides equal emphasis on State institutions and social arrangements to achieve a long term growth.

Rodrik explains the importance of institutions with the examples of Botswana and China. The tribal institutions of Botswana played a major role in its economic growth. In China, transitional institutions suited to the local circumstances greatly aided in its economic growth. Thus Rodrik argues that institutions should have elements that are highly specific to a country’s circumstances.


The nature and role of State, market and institutions have undergone many changes since the emergence of development economics from 1940s and 1950s. During the initial period, State had a larger role to play in economic development. Later the market was allowed to operate freely in many aspects with a strong State to regulate the economic activities. The role of institutions was given prominence only from the 1980s. Development economists including Ha-Joon Chang, Deepak Nayyar, Pranab Bardhan and Dani Rodrik put a great emphasis on the establishment of quality institutions.

                Thus it can be argued that the role of state and market should be based on the developmental objectives of a specific country. There cannot be a universal approach in defining the roles of state and market. It also depends on the degree of development of a country and the capacity of market to take over the activities of the State. The view of Rodrik can also be accepted that the development of institutions should be based on the circumstances prevailing in a country. In the era of globalization, it can be accepted that the State has a larger role to play in regulating the activities of the market and also for human development. Thus strong interrelationships exist among the State, market and institutions in the economic development of a country.

[1] Eric Thorbecke “The evolution of Development doctrine, 1950-2005”

[2] Ha-Joon Chang “The Market, The State and institutions in economic development”

[3] Ha-Joon Chang “The Market, The State and institutions in economic development”

[4] Deepak Nayyar “Globalisation and development strategies”

[5] Pranab Bardhan “Institutions and Development”

[6] Dani Rodrik “In search of prosperity”

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