The Green Book

GOVERNMENT INTERVENTION

ANNEX

INTRODUCTION

This Annex discusses the rationale for government intervention, whether via a new or changed policy, a programme or a project. It is essentially twofold:

	The achievement of economic objectives by addressing inefficiencies in the operation of markets and institutions; and,
	The achievement of an equity objective, such as local or regional regeneration.

ECONOMIC EFFICIENCY

Economic efficiency is achieved when nobody can be made better off without someone else being made worse off. Such efficiency enhances prosperity by ensuring that resources are allocated and used in the most productive manner possible. One potential cause of inefficiency is where circumstances mean that the private returns which an individual or firm receives from carrying out a particular action differ from the returns to society as a whole. Market failure is a description of a situation where, for one reason or other, the market mechanism alone cannot achieve economic efficiency. This can occur for a number of reasons, which are briefly discussed below.

Public Goods

The market may have difficulty supplying and allocating certain types of products and services, such as ‘public goods’. Public goods are those that are ‘non-rival’ or ‘non-excludable’ when used or consumed.

	‘Non-rival’ means that the consumption of the good by one person does not prevent someone else using or consuming that good. Clean air is an example of a non-rival good.
	‘Non-excludable’ means that if a public good is made available to one consumer, it is effectively made available to everyone. National defence is an example of a non-excludable good.

Non-excludability can give rise to a problem known as ‘free-riding’. This is when some consumers fail to pay for the provision of the public good because they expect others will do so. This implies that the returns to potential suppliers will be less than society as a whole would be willing to pay collectively. So a market solution would imply too little public goods being produced to be socially optimal.

Externalities

‘Externalities’ result when a particular activity produces benefits or costs for other activities that are not directly priced into the market. Externalities are associated with, for example, research and development spill-overs, and environmental impacts, such as pollution. A firm might keep down its own costs by not investing in water pollution controls, but in so doing would raise the costs of those firms and individuals relying on using clean water. As a result the polluter has imposed an external cost on other users, or alternatively, a reduction in pollution confers an external benefit upon these other users.

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Imperfect Information

Information is needed for a market to operate efficiently. Buyers need to know the quality of the good or service to judge the value of the benefit it can provide. Sellers, lenders and investors need to know the reliability of a buyer, borrower or entrepreneur.

This information must be available fully to both sides of the market, and where it is not, market failure may result. This is known as ‘asymmetry of information’ and can arise in situations where, for example, sellers have information that buyers don’t (or vice versa) about some aspect of product or service quality. Information asymmetry can restrict the quality of the good traded, resulting in ‘adverse selection’. Another possible situation is where a contract or relationship places incentives upon one party to take (or not take) unobservable steps that are prejudicial to another party. This is known as ‘moral hazard’, an example of which is the tendency of people with insurance to reduce the care they take to avoid or reduce insured losses.

Market Power

Market power can arise as a result of insufficient actual or potential competition to ensure that the market continues to operate efficiently.

High start up costs can deter entry by competitors in the first place, and therefore create market power. This situation may be exacerbated through organisations acting strategically to protect their position in the market. Examples of this are when an organisation invests in any excess capacity available in the market, or engages in a practice known as ‘predatory pricing’ where prices are set low (e.g. below the marginal cost of production) to drive out competitors and then raised once they have left.

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EQUITY

The other important rationale for government intervention is the achievement of equity objectives. Before acting, an assessment should be made of the extent of the inequality to be redressed, and the reasons it exists.

Further detail on the treatment of equality in project appraisal is provided in Annex 5.

ADDITIONALITY

The success of government intervention in terms of increasing output or employment in a given target area is usually assessed in terms of its ‘additionality’. This is its net, rather than its gross, impact after making allowances for what would have happened in the absence of the intervention. Additionality can also be referred to as a ‘supply side’ or ‘structural’ impact, which operates by altering the productive capacity of the economy. This can occur either because of a change in the size of the workforce or a change in the productivity of the workforce. Examples of interventions that promote supply-side benefits include improving the working of markets and economic institutions, strengthening capabilities, and facilitating greater participation in the workforce. The extent to which a proposal may produce a supply side benefit is an important component of an appraisal.

If there are no grounds for expecting a proposal to have a supply side effect, any increase in government expenditure would result in a matching decrease in private expenditure, (known as ‘crowding out’). If, however, the supply-side impact of a proposal is expected to be positive, the net additional impact on economic welfare will need to be measured. This may consist of additional employment or output, and constitutes a real net benefit which the appraisal should take into account.

Estimating this type of additionality will normally require an analysis of the product, labour, and in some cases, capital markets affected by the intervention. For example, when assessing the level of displacement of an employment creation programme or the impact of recruitment and redundancy decisions on a particular local area, it is necessary to examine the characteristics of the jobs created, or protected, in relation to the characteristics of the local labour market. They must then be compared with similar jobs in other local areas that are not subject to the policy. Such a comparison establishes the ‘do nothing’ case: what would have happened if the intervention had not gone ahead.

In some cases, the best source of information for assessing additionality may be from those who clearly have an interest in the outcome of the decision. In these circumstances, the information and forecasts should be confirmed by an independent source. For example, the implied growth in demand for services might be compared to other forecasts for the same region, and contrasted with past performance. Sensitivity analysis should also be carried out, using alternative values for the key variables.

After developing the ‘do nothing’ case, the next step is to assess the net impact or benefit of these different options. This net benefit is the ‘additionality’ of the option. Additionality must, however, be calculated with consideration of ‘leakage’, ‘deadweight’, ‘displacement’ and ‘substitution’ effects. These are explained below.

	‘Leakage’ effects benefit those outside of the spatial area or group which the intervention is intended to benefit.
	‘Deadweight’ refers to outcomes which would have occurred without intervention. Its scale can be estimated by assessing what would have happened in the ‘do minimum’ case, ensuring that due allowance is made for the other impacts which impact on net additionality.
	‘Displacement’ and ‘substitution’ impacts are closely related. They measure the extent to which the benefits of a project are offset by reductions of output or employment elsewhere.

For example, a project may attract scarce skills, or investment, which would otherwise have gone to other parts of the country; or, if the policy involves support for local businesses, these may compete for resources and / or market share with non-assisted businesses.

The appropriate area for analysis of displacement effects will depend on the type of project. In the case of employment displacement, the area considered should usually approximate the local labour market.¹

The effect on net employment and net output is likely to be much smaller than the direct employment and output effects of the project. Evidence should support the assessment of the scale and importance of any net employment and net output benefits, taking account of multiplier effects. A multiplier measures the further economic activity, (whether output or jobs), resulting from the creation of additional local economic activity. Where it is considered appropriate to calculate multipliers, guidance is available from English Partnerships and the Regional Development Agencies.²

The net benefit of an intervention equals the gross benefits less the benefits that would have occurred in the absence of intervention (the ‘deadweight’) less the negative impacts elsewhere (including ‘displacement’ of activity), plus multiplier effects.

If there is no improvement in national economic efficiency, local employment and output effects, net of any local displacement effects, may be considered in parts of the appraisal where the project has a strong distributional rationale. For example, a policy may aim to reduce the rate of unemployment in a particular deprived area, as opposed to reducing the rate of unemployment overall.

Where potentially large changes to employment, (either as a result of employment creation, protection or redundancy) are concerned, assessment will normally require a thorough analysis of the local labour market. This should cover the age, skills and experience of those whose jobs are at stake, and how these compare with the characteristics of the unemployed and those who have recently found employment. The analysis might also assess the likelihood of new investment in the region in the event that these job losses occurred.

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REGENERATION

Specific issues arise in the appraisal and evaluation of regeneration projects that have a rationale defined both in terms of their impact on efficiency and equity. In many cases, these projects are aimed at the regeneration of local areas, although some are targeted at entire regions.³

Regeneration Issues

When considering a regeneration proposal the following issues should be addressed:

	The rationale
	This needs to make clear:
		Who the intended beneficiaries of the project are;
		What are the mechanisms which will extend the benefits to them;
		What structural benefits are expected as a result of the project; and,
		The means by which these will be achieved.
	The objectives
	The objectives of regeneration programmes are likely to include improvements in one or more of the following:
		Labour supply and skills;
		Quality of life;
		Physical environment; and,
		Local business opportunities.
	Outcomes
	These should be identified with respect to the relevant intermediate objectives. Regeneration outcomes might include:
		Reductions in crime;
		Improvements in the capacity of community organisations; or,
		Increases in local incomes and employment.
	Partnerships
	Partnerships between the local community, business and government are important for the sustainability of regeneration projects and the well being of local communities. Most local regeneration projects involve partnerships, and are likely to have some effect on existing institutional relationships. An appraisal should include a description of the partnership and, where possible, its expected impact on the area.

Government intervention in the economy is sometimes undertaken with an employment objective in mind. In other cases, although employment is often retained as a principal objective, the justification for intervention is more far-reaching and the objectives tend to be more broadly cast. This is typical of regeneration projects.

Where programmes have multiple objectives, such as environmental improvements, these other additional benefits (and any associated costs) should be covered in the appraisal, together with employment impacts. The geographical focus of regeneration projects means that it is particularly important to assess displacement effects at both the local and national levels, particularly if the programme or project is substantial.

State aids

State aids are transfers of state resources which provide selective support to particular companies. When the state confers even a limited advantage on an undertaking, there is usually a distortion, or risk of distortion, of competition. To protect competition across the EU, the European Commission provides a complex body of treaty-based legislation, frameworks and case law to establish which aid is, and is not allowable.

Aid is payable through a large variety of measures and instruments, including tax relief, soft loans and provisions to help prepare an undertaking for privatisation as well as grants and subsidies. As such, it is important that the state aid rules are considered from the onset of any proposal to ensure that proposed measures will be compatible with EU competition rules.

Further detail is available from the DTI and the European Commission.⁴


1	Detailed guidance on methodologies for assessing displacement effects is available from the DTI Central Evaluation Team web site at http://www.dti.gov.uk. The recent DTI/ SBS evaluation of ‘Smart’, available on the same web site, provides an applied example. Also useful is research undertaken for DTI by the University of Durham (http://www.dur.ac.uk) and DWP’s Travel to Work Areas.
2	For example, see ‘Additionality: A Full Guide’ (English Partnerships, 2001)
3	More detail is provided in ‘A Framework for the Evaluation of Regeneration Projects and Programmes’, (EGRUP) available from HM Treasury, 1995 (currently under revision).
4	See the DTI website (State Aid Policy Unit): http://www.dti.gov.uk and the European Commission’s website on competition http://www.europa.eu.int.