Simon Hooton's Regeneris Blog

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Simon

The future of business support in England at least, appears set to be characterised by four dominating areas of focus:

• Getting out of businesses’ way: reduce barriers to business formation, ease the regulatory burden on existing companies, simplify tax and employment obligations and reduce the overall cost of competing.
• Better access to finance: opening up bank lending to small businesses and encouraging new sources and vehicles to come forward
• Expanding trade & inward investment: the current macro-economic climate underlines the need to generate demand for goods and services from outside the UK. We also may need to corner more than our fair share of footloose international businesses to create new employment in the UK.
• Innovation led growth: developing new and greener products & services, enhancing productivity based on Intellectual Property, and competing in higher value and more competitive markets all demands UK businesses step up their innovation commitment.

Business support will bear its fair share of cut-backs in the coming years and the themes above need to be pursued under tight financial constraint. Even with priority status, public investment will fall from current levels in these areas and new more creative, lower cost solutions will be needed. Regeneris Consulting believes that more attention is needed on market failure when designing public interventions in the future. Despite progress in better understanding the different types of market failure, further more practical applied tests and better use of evidence are needed to ensure a more robust and consistent approach at the investment decision-making stage. When few resources are available and private sector growth is fragile, the risks of crowding out and duplication are significant. Practically testing whether an intervention is justified demands answers to the following core questions:

• Is there demonstrable evidence of a recognised market failure? We have set out descriptions of the main market failures affecting business support below, along with some key questions to assess their relevance. 
• Can public sector intervention make the situation better? solutions must be designed to tackle the identified market failure, avoid mission creep, be of sufficient scale to make a real difference and, over time, lead to a sustainable long-term market based solution from which the public sector could exit.
• Do the costs of intervening to the taxpayer outweigh the benefits to the economy and businesses? If not, the case for investing must be in real doubt.

At the core of most market failures lie externalities (or spillovers) i.e. costs and benefits unwittingly imposed upon people and businesses. Examples of negative spillovers include poor quality public realm, hazardous emissions and contaminated land, whilst positive externalities ar e associated with a strong base of R&D and a well-trained pool of labour. Externalities are not reflected in the price paid by the consumer or the costs of the producer and are imposed upon people and businesses not responsible for their production or consumption. Without a mechanism to allocate these costs fairly, there is no effective means of limiting/influencing their continued production through conventional market means.

The public sector has traditionally intervened to reduce the effects of negative externalities through the legal and regulatory system and endeavoured to harness positive externalities through economic development investment. For example R&D can generate positive spillovers far beyond the returns to the original investors and, despite a system of patents and copyrights, fears that new technologies can leak out to competitor businesses can limit investment in R&D. A highly trained workforce has clear positive spillover benefits for all businesses, regardless of whether they themselves have invested in training or workforce development. Concerns about losing trained staff to competitors (poaching) are likely to suppress investment in training to below the optimally efficient levels.

Spillovers can also be generated where there is a concentration of factors of production which a series of business require. If these factors such as labour supply, know-how, infrastructure, sites & premises, finance and even reputational issues exist in sufficient concentration, an agglomeration effect might be stimulated. Co-location of firms confer positive spillovers on others through a common labour pool, supply chain, or knowledge base and by collaborative interaction between businesses, suppliers and people. Under such circumstances economic growth may be accelerated over and above what might happen if the same scale of activity were more dispersed or the scale of activity were smaller. But this requires a critical mass to be reached and requires a concentrated programme of investment to exceed the sum of its parts. This logic is used to justify clustering initiatives, science park and city-centre redevelopment.

The potential existence of externalities is a really useful starting point to developing a rationale for public sector intervention, but it is often not enough. Externalities occur in many sectors, markets and locations, arguably too many for the resources available from the public purse. Further understanding is needed when designing business support schemes of what we have called, the Market Failure Drivers. These are the factors which prevent the market operating efficiently and can help guide public interventions onto those issues where a real impact can be made. The Drivers include Partial Public Goods, Information Failures, Coordination Failures, Scale Failures and Historic Failures.

Regeneris Consulting has reviewed the rationale for a wide range of business support schemes and the associated academic literature. We have developed a series of practical tests which the public sector could use to identify whether the market failures are substantive and whether they could be tackled through intervention. Please get in touch if you would like to hear more about how these complex concepts can be practically and easily addressed.