I. Introduction II. The Importance of the Private Sector in Third World Development III. Nature of the Challenge to the Development of Market Economies in LDCs IV. A.I.D. Policy to Meet the Challenge V. Specific Components of the A.I.D. Policy VI. The Responsibilities of Missions and Regional Bureaus ANNEX A Wednesday, 11-Jul-2001 16:54:12 EDT

A. Economic Importance

The most efficient allocation of scarce resources occurs when individuals seek to increase their incomes in an environment characterized by open competition in the supply and exchange of goods and services. When complemented by prudent management of necessary government services, the aggregate effect of individual free market behavior is growth and development of the economy at large.

However, many LDCs have not relied on open, competitive markets to determine resource allocations in many sectors of their economies. Rather, LDC governments have attempted to direct essential activity in agricultural and industrial production and trade by administrative determinations. Except for small-scale activities often characterized as informal, the economies of many LDCs are marked by extensive government efforts to determine production levels, prices and consumption patterns.¹ A wide variety of historic, ideological and other reasons explain a particular LDC's mix of public and private sector activities.

Aside from the provision of universally accepted public goods like national defense, public safety, monetary policy and enforcement of contracts, further government involvement in an economy follows from the belief either that a market cannot be established or that the result of market decisions will lead to socially unacceptable outcomes. In certain cases, such as natural monopolies, goods with important externalities, and merit goods (See Annex A for definitions), a government may determine that public involvement in production or distribution is important to achieve social objectives. But it is clear that LDCs which have overextended the role of the public sector and restricted the operation of the private sector have experienced slow growth, heavy budget deficits and rising debt burdens.

LDCs that maintain a broad definition of natural monopolies and public goods pay a higher price in overall economic growth. Such countries have typically experienced real per capita growth averaging 3% per year over the last ten years. Many have been at or near zero growth. However, those LDCs which have more narrowly defined the role of the public sector and allowed competitive markets to determine the price and quantity of most goods and services have experienced growth, rates averaging 7% per year.²

In terms of equity, countries with a high level of government interference in the market fare no better in the short run than market economies, probably because slow growth reduces employment opportunities.³ In the long run, government dominated economies may fare worse, because sustaining equity-oriented services becomes difficult when growth, and therefore revenue, lags.

Government is thus in a unique position to establish a favorable climate for private investment. Moreover, that climate is critical to the attainment of both economic growth and equity objectives. The extent and nature of public and private sector roles must be defined and balanced to ensure equal access to opportunities and high economic growth. This is the challenge in A.I.D.'s private enterprise policy.

B. Social Importance and Human Rights

Economic freedom for individuals -- an essential condition for viable competitive markets -- encompasses the notion of the right of persons to make personal choices in providing for their livelihood and that of their families. Such economic freedom permits individuals to pursue, within the bounds of generally accepted norms of behavior, activities which utilize their comparative advantage in innate capabilities, acquired skills and interests.

The essentially independent decisions of suppliers and consumers in competitive markets result in a diffusion of economic power. The greater the competitiveness of the market and the economy at large, the more dispersed is the power to influence the market and the economy for individual gain. Free markets are the most effective way of mobilizing human energies, assuring responsiveness to consumer demands, and avoiding the exploitation of the poor typical of public or private monopoly or oligarchical enterprise. Given the close association of economic power with political power, a key attribute of a society which permits free competitive markets is a pluralistic body politic. As LDCs remove restrictions on the operation of markets, they are simultaneously encouraging behavior which supports the development of popular representative political institutions. A democratic government is not an automatic outcome of a competitive market environment. However, competitive markets generate greater likelihood of progress towards a form of government which provides for popular representation than towards authoritarian forms of government. Furthermore, a society in which economic power is widely dispersed is more likely to be one in which transfer of political power by election is permitted than in a society where exclusion from political power carries with it exclusion from economic power.

A.I.D. notes that when representative institutions emerge in a free market economy, reciprocal benefits in the form of efficiencies in the provision of public goods and services are likely to occur. In societies which permit open debate, the levels of public goods supplied and the roles of state authorized monopolies are adjusted in the normal political process to the particular level of popular demand. These adjustments attempt to minimize the social and financial costs of these exceptions to competitive markets. However, adjustments in authoritarian societies may not occur until a situation becomes untenable; an abrupt restructuring may then follow civil unrest, a coup d'etat or revolution. The society pays an ever increasing price in terms of reduced growth and inequity before the change takes place. Furthermore, the abrupt nature of the change may only produce a different but equally inefficient solution to the supply of goods and services provided or controlled by the public sector.

²Agarwala, Ramgopal, "Price Distortions and Growth in Developing Countries," World Bank Staff Working Papers Number 575, 1983.
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³For a convincing case showing how the expansion of the public sector has stretched the managerial capacity in many countries see The World Bank, World Development Report 1983. See also Alvin Rabushka, Free Markets and Economic Development in Postwar Developing Countries (December 1983) which shows how most of the countries which have outgrown poverty in the Post-War II period have emphasized free market economic policies.
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