Industry Comment

Simon Hooton / Director, Regeneris Consulting

October 2007

 

No-one really believes that markets, left to their own devices, will necessarily deliver the most efficient and effective outcomes for society. And yet the invisible hand of the perfect market, where supply matches demand and scarce resources are efficiently allocated, is the foundation to the study of economics.

In fact, I believe there is more evidence that green men exist at the bottom of the garden than there is for the existence of a perfect market in the fields of economic development and regeneration.

On the other hand, there is plenty of evidence that markets are the least worst mechanism for allocating resources between competing interests and uses. Markets allow individuals and businesses to make judgements about what to consume and what to supply, when to take risks, when to retrench and when to diversify. And more often than not, freely-set prices send signals that help everyone else decide how to respond.

The truth is that markets work and markets fail. The real challenge is to be able to identify when they have failed and to understand how best to intervene. Since 2000, the Regional Development Agencies (the Government’s weapon of choice in building prosperity) have paid more and more interest to this concept.

 

 

 

 

 

 

 

 

 

 

 

A strong assessment of market failure depends on good research, structured thinking and a strongly articulated proposition. Regeneris Consulting has moved beyond the usual long checklist of market failures to develop a useable toolkit to help in project and programme appraisal.

Applying market failure thinking should ensure there is a clear logic for why public agencies intervene. It’s perhaps not surprising that market failure has risen to the fore as the Treasury turns its thumbscrews on public spending, but applying market failure to justify public intervention needs careful handling. As we shall see, market failure comes in all shapes and sizes.

 

Testing for market failure

 

Testing the idea of market failure is essentially a five-step process:

Step 1 – What is the rationale for intervention? What are you trying to achieve, and why? Is it to improve economic efficiency and overall wealth or is it because the current outcome is seen as unfair to certain groups in society, such as BME communities or the digitally excluded?

Step 2 – What precisely is the market failure being addressed? Is there evidence that the market failure is leading to serious inefficiencies, such as an undersupply of goods and services that would benefit society (like skills and training) or an excess due to irrational decision-making underpinned by limited market information?

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Step 3 – What’s the role of the private sector and could this be damaged by intervention? We need to understand exactly what and how the private sector is operating; it’s rarely true that there is absolutely no private sector activity and there is a risk that clumsy public sector intervention can crowd out private sector investment. Subsidies towards property or business advice – as has been the case in areas receiving large chunks of European Union funding, such as Merseyside and Northern Ireland – can make it less likely for private firms to enter these markets.

Step 4 – What’s the evidence that public intervention works? Markets may not work perfectly, but it does not follow that the public sector will do a better job: it might even make matters worse! Anyone familiar with the world of economic development can certainly point to government failure, which despite the best of original intentions has created perverse incentives or not done anything more than scratch the surface without actually tackling the real problems, and in the process simply clocked up an even bigger bill for the taxpayer.

Step 5 – Is the design of the project logical in the light of its original rationale? It is usually far better to work with the market than to try and replace it. In business support, this means the first port of call should be to provide a route to private suppliers of business advice rather than creating alternative publicly-funded sources.

 

Better value for the taxpayer

 

Armed with these sensible tests for hunting it out, we believe that better investment decision-making can be built around the concept of market failure. Using this approach to intervention can offer a better deal for the taxpayer because it:

 

• focuses spend in those areas where the private sector isn’t operating effectively, avoiding the risks of wasteful duplication;

• minimises distortion in the market which reduces unfair advantage to others and limits the degree to which new businesses are deterred from entering the market;

• concentrates investment on tackling the heart of the matter, and steers us away from well-intentioned but broad-brush approaches which promise to solve more than they possibly can;

• encourages investments which supplement market institutions and mechanisms, rather than building costly new ones entirely from scratch;

• and, provides greater scope for a steady and progressive exit in such a way that boosts the likelihood of a better operating market being left behind.

 

Put simply, the free market often breaks. And, when it does, make sure you use the right tools to sort it out. On the other hand, if it ain’t broke, don’t fix it.

 

Market failure: a glossary

Market failure comes in many forms and is by no means clear-cut in its scope and definition. The most widely recognised failure is that of the 'public good', an item (such as defence, public health and the rule of law) which benefits everyone, whose costs of production don’t go up in line with consumption and for which it is impossible to exclude users. This classic form of market failure is central government territory and is not directly relevant to local and regional economic development. For us, the more relevant and interesting failures are:

 

Spillovers (or externalities): these are the knock-on consequences which any investment may generate or which any challenging situation imposes on people and businesses not directly engaged in the transaction (and also known by economists as externalities).

These are the most widely known and understood market failure. They are the value or costs which are not easily captured by the market mechanism which the market either delivers too much or too little of. Examples include the extra trade local businesses would get from local improvements to the public realm or the benefits to the rest of the economy of a well trained workforce or a cluster of highly competitive businesses operating in a concentrated area.

On the flip-side, negative spill-overs would include the brake on investment created by derelict sites owned by a distant landlord and the impact of pollution on neighbours of a factory. These spill-overs are present everywhere, but public sector interventions based on these grounds must be designed to really maximise the positive and to eliminate the negative.

 

 

 

 

 

 

 

 

 

 

 

 

 

Spillovers are present everywhere, but public sector interventions based on these grounds must be designed to really maximise the positive and to eliminate the negative. One solution can be to try to develop mechanisms to capture the benefits and costs; Business Improvement Districts are a recent example of just such an intervention.

Public goods: these are goods which, when produced, benefit everyone and are impossible to exclude users from. By consequence, they are not amenable for charging: defence, public health and law and order would be examples. Regional and local economic development agencies will not be dealing in these areas: this is central government territory.

Partial public goods: these are goods whose benefits are shared broadly and where it is unrealistic to charge all beneficiaries in line with their consumption and the benefit they derive from them. Examples include awareness-raising campaigns such as those to boost uptake of ICT where wider society stands to benefit, or certain types of infrastructure where charging for use is not realistic.

Information failures: markets need information to set prices and people can't make informed and rational choices when appropriate information is not readily available. Although access to information is always going to be limited there comes a point where it begins to affect people's decisions about the volume, price and risk associated with different goods and services This is the main rationale for the provision of free information, diagnostics and brokerage (IDB) to business support services delivered by Business Link for SMEs.

Co-ordination failures: joint ventures across a wide range of actors can be difficult to get off the ground. Potentially lucrative initiatives might fail if no-one steps forward to instigate action. The public sector may have a role in triggering action, for instance through cluster networking projects, complex physical site development or collaborative R&D initiatives. After the initial stimulus, the public sector’s role should disappear as the venture acquires its own momentum: co-ordination failures would not normally justify long-term public investment.

Scale failures: where the ideal scale of investment may be larger than private sector investors and developers alone are likely to provide, for example the need for co-ordinated housing market renewal across a broad area (which can work in conflict with small-scale private developments) or mass media promotional campaigns for a tourist or inwards investment destination.

Path dependency failures: where an economy becomes locked into a pattern of consumption, production or behaviour which then prevents people and businesses from making efficient choices. This failure is usually applied to a local area or economy, which has experienced a prolonged period of unemployment which has eroded the local skills-base or through a reluctance to shift away from obsolete technology.

Institutional Failures: where there is an existing public sector intervention which is either not succeeding or detracting from more important economic goals. For example, the operation of the welfare benefits systems can create perverse incentives which undermine efforts by other interventions to get people back into work, while the education system is not producing work-ready candidates for employment. Interventions in this arena should ideally seek to influence existing public initiatives rather than replicate them.

Equity Failures: where the operations of the market lead to deprivation, poverty and inequality in society which hold back regional prosperity. Although not strictly a market failure (as the perfectly efficient market never promised to ensure fair shares for all), this failure is recognised as providing grounds for intervention by the Treasury. Although there are inequalities all around us, interventions to tackle inequalities need to show they can ultimately lead to a sustainable outcome in the mainstream economy.

 

More information...

 

For more help on demystifying market failures contact Simon on 0161 926 9214 or email s.hooton@regeneris.co.uk.

 

Send us your thoughts...

 

We’d love to receive your feedback on this article and hear about your own experiences of attempting to identify market failure to prove the case for a public project. Please email comment@regeneris.co.uk with your views.