Scottish Enterprise
Strategy and Economics:
Appraisal & Evaluation team
Rationale for Intervention Guidance
October 2010
Contents
1.
Introduction ....................................................................................................... 2
1.1.
Purpose of this guidance note .................................................................. 2
1.2.
Why is the rationale for intervention important?....................................... 2
1.3.
Links with internal and external guidance ................................................ 2
1.4.
Who is the guidance for?.......................................................................... 4
2. The Justification for Scottish Enterprise’s Intervention in the Market.............. 5
2.1.
Background............................................................................................... 5
2.2.
What would an efficient market look like? ................................................ 5
2.3.
What makes up the rationale for public sector intervention? ................... 6
2.4.
Wider reasons for public sector intervention ............................................ 7
3. Defining the Rationale for Public Sector Intervention ...................................... 9
3.1.
Key steps in exploring the rationale for intervention ................................ 9
3.2.
Identifying the issue .................................................................................. 9
3.3.
Assessing the broad rationale for intervention ...................................... 10
3.4.
Exploring the rationale in more detail ..................................................... 12
3.5.
Considering approaches to rectify the problem ..................................... 12
4. Efficiency Rationale ........................................................................................ 15
4.1.
Background............................................................................................. 15
4.2.
Information failure (imperfect information) ............................................. 15
4.3.
Information failure (asymmetric information).......................................... 17
4.4.
Externalities (spillovers) .......................................................................... 19
4.5.
Public goods ........................................................................................... 21
4.6.
Market power .......................................................................................... 22
5. Equity Rationale ............................................................................................. 24
5.1.
Background............................................................................................. 24
5.2.
Key questions to identify equity rationales ............................................. 24
6. Environment Rationale ................................................................................... 26
6.1.
Background............................................................................................. 26
6.2.
Key questions to identify environmental rationales................................ 26
7. Presenting the Rationale for Intervention ...................................................... 27
8. Summary and Checklist ................................................................................. 28
Appendix 1: Growing globally competitive business examples
30
Appendix 1.1: Internationalisation examples
31
Appendix 1.2: Inward investment examples
33
Appendix 1.3: Enterprise examples
34
Appendix 1.4: Account management examples
35
Appendix 1.5: Specialist advisory support examples
36
Appendix 1.6: Commercialisation examples
37
Appendix 1.7: R&D and Innovation examples
39
Appendix 2: Globally competitive business environment examples
41
Appendix 2.1: Business Infrastructure examples
42
Appendix 2.2: Equity investment examples
44
Appendix 2.3: Local regeneration / urban regeneration examples
45
1
1. Introduction
1.1. Purpose of this guidance note
The aim of this guide is to provide a practical framework for developing or
assessing the rationale for intervention associated with new projects or
programmes being brought forward for funding.
The detailed objectives of this guide are to:

Help identify the main steps in defining the type (or types) of rationale
for intervention

Provide detailed questions that can be used to explore the rationale for
intervention in a systematic and evidence based way

Provide practical examples associated with efficiency (market failure)
rationales under key Scottish Enterprise intervention areas to aid
analysis (Appendices 1 and 2).
1.2. Why is the rationale for intervention important?
The rationale for intervention is important as a strong understanding of the
need for intervention is a key element in designing effective and efficient
projects and programmes.
This is because a well defined rationale for
intervention will inform the development of activities that address the underlying
problem and therefore have a greater chance of success. A clear rationale for
intervention will also mean that it is likely that the economic impact of any
intervention will be greater as there will be clear targeting of interventions.
1.3. Links with internal and external guidance
The rationale is a key part in the Scottish Enterprise project lifecycle – covered
in the strategic outline case of the Five Business case model that SE uses1. It
sits within the first stage of the process in the development of the strategic
outline case: business justification. This element confirms the strategic context
of the proposal, makes a robust case for change, provides SE management
with an early way forward on a wide range of options, together with indicative
Scottish Enterprise: An Introduction to Business Cases – The Five Case Model –
Guidance – Version 1.3
1
2
costs and benefits. The rationale for intervention is assessed based on two
core questions at the stage 1 review covering:

Confirming the case for change – i.e. what is this project actually going
to achieve and why do we need to do it?

Has an analysis been made of the market situation identifying causes of
market failure or other grounds for public intervention?
The rationale also fits with wider external guidance outlined in the HM Treasury
Green Book2, the key reference source on public sector intervention, which
states that:
‘before any possible action by government is contemplated, it is important to
identify a clear need which it is in the national interest for government to
address’.
The rationale is therefore the first step in the policy development cycle (also
known as the ROAMEF cycle3), with the Rationale being developed first, then
setting Objectives for activities to overcome the failure, Appraisal of the
proposed approach, ongoing Monitoring of the project over time and then
Evaluation and Feedback into project practice or subsequent project
development. Diagram 1.1 below highlights the place of the rationale as the
starting point in the policy development cycle.
Diagram 1.1: The Policy Development Cycle
Rationale
Feedback
Objectives
Policy Cycle
Evaluation
Appraisal
Monitoring
2
HM Treasury (2003) The Green Book: Appraisal and Evaluation in Central
Government, HM Treasury.
3
Rationale, Objectives, Appraisal, Monitoring, Evaluation and Feedback
3
The key is that the rationale for intervention is a crucial first step in the process
of developing projects that can lead to the achievement of the ambitions in the
Government Economic Strategy4 through Scottish Enterprise’s intervention.
1.4. Who is the guidance for?
This guidance note is intended to support project or programme owners,
engaged in the development of projects and programmes, to fully articulate the
rationale for intervention.
The approaches outlined in this note are also
recommended for use by Scottish Enterprise’s external contractors.
4
Scottish Government (2007) The Government Economic Strategy, Scottish
Government
4
2. The Justification for Scottish Enterprise’s Intervention in the Market
2.1. Background
Private sector companies intervene in the market primarily because they feel
that they can undertake activities that will generate a surplus over the cost of
delivering whatever goods or services they provide.
The justification for public sector intervention differs in that it is primarily driven
by a desire to overcome some of the consequences of the market that are felt
to be economically, socially or environmentally undesirable. The economic
development consequences might be such things as lower than average
company formation rates, poorly trained staff resulting in low productivity, the
inability of companies to raise capital or an unwillingness to adopt new and
more productive processes or procedures.
Ultimately the aim of Scottish Enterprise is to ensure that the Scottish market
operates as efficiently as possible and delivers the Government Economic
Strategy’s vision of creating a more successful country, with opportunities for
all of Scotland to flourish, through increasing sustainable economic growth.
2.2. What would an efficient market look like?
In an efficient market resources are allocated in such a way that no one can be
made better off without someone else being made worse off. This would
mean:

A supplier is able to exclude consumers from consuming their product
for free

Producers and consumers must bear the full costs and benefits of their
activities

There would be no waste of resources in the production and allocation
processes

All parties to a transaction would have equal access to information
about the goods or services on offer.
This is the notion of the ‘perfect’ market. Needless to say such perfect markets
do not exist, so invariably there are many opportunities for public sector
5
intervention. As this represents a perfect scenario we use the wider concept of
a market being efficient if the benefits of activities exceed the costs of the
activities. From an SE perspective this would be a situation where the benefits
generated by an intervention exceed their costs and go some way towards
rectifying the initial problem. This could include:

Greater levels of productivity generated by businesses through account
management

Increased investment in research and development leading to improved
business performance through R&D grants

The minimisation of waste by companies leading to increased
profitability through support from the Scottish Manufacturing Advisory
Service

Fair and equitable access to debt and equity funding leading to quicker
and more sustainable business growth through support from the SEED,
Co-Investment or Venture funds.
2.3. What makes up the rationale for public sector intervention?
The gap between perfection and reality and the adverse consequences of the
operation of markets give rise to three main justifications for intervention by
economic development agencies. The rationale for intervention can be defined
as falling within one (or more) of three broad areas – better known as the 3E’s5:

Equity – intervention to ensure the even distribution of outcomes
(across groups or places), or the achievement of wider social objectives
(such as the participation strand of the Government Economic Strategy)

Efficiency – intervention to ensure the achievement of economic
objectives by addressing inefficiencies in the market, the classic market
failure argument

Environment – intervention for sustainability, either through the
reduction of harmful environmental impacts or maximisation of positive
environmental impacts (this is actually a special case of efficiency and
5
Communities and Local Government (2007) Communities and Local Government
Economics Paper 1: A Framework for Intervention, Department for Communities and
Local Government: London.
6
equity objectives, but deserving of consideration in its own right due to
the Government’s strategic objective to develop a greener Scotland).
These three broad areas make up the rationale for intervention. An important
qualification to this is that the existence of a rationale is not enough in itself to
warrant intervention. The two key factors that drive scope for intervention
focus on:

The extent of the rationale – the greater the extent or severity of the
rationale the stronger the case for intervention

The ability of the intervention to generate benefits that exceed the cost
of intervening and go some way towards correcting the problem. The
implication of this is that the existence of a market failure or equity
concern is not of itself justification for intervention. Any such
intervention needs to have some chance of solving or alleviating the
underlying problem.
Each of the three rationales is explored in the sections that follow, including
core questions that can be asked to build the evidence around each of the
areas.
2.4. Wider reasons for public sector intervention
While the 3E’s represent the main areas that make up the rationale for
intervention, there are also three other areas that are increasingly used to
justify public sector intervention. It is important to recognise that these actually
result from some of the efficiency arguments around market failure (or wider
rationales such as equity or environmental issues), but warrant explanation in
their own right – and when used should make reference to the underlying
rationale for intervention based on the 3E’s. Where these cannot be linked to
the wider rationale for public sector intervention it is not generally the role of the
public sector to intervene, unless a clear wider case can be made.
The three wider areas cover:
7

Institutional failures – interventions designed to correct the unintended
consequences or ineffective activities of previous government
intervention6

Co-ordination failures – the situation when parties involved in a
transaction cannot reach agreement, usually because of the cost of
negotiating to reach an agreement7

Opportunity rationales – where there is an opportunity for the public
sector to act as an enabler for the exploitation of a particular opportunity
It is important to recognise that these areas do not represent fully legitimate
reason for public sector intervention. However, when linked with a wider
underlying rationale for intervention they can be used as the basis for activity.
6
OffPAT (2009) OffPAT Advice Note 1/2009, The Rationale for Public Sector
Intervention: In Economic Development and Regeneration Programmes and Projects
7
GLAEconomics (2008) The Rationale for Public Sector Intervention in the Economy,
London Development Agency, Transport for London and Mayor of London
8
3. Defining the Rationale for Public Sector Intervention
3.1. Key steps in exploring the rationale for intervention
A number of steps can be followed that will help in identifying the type (or
types) of rationale for intervention. These cover:

Preliminary work to identify the issue

Assessment of the issue in terms of the rationale for intervention

Exploration of the specific rationale for intervention in more detail

Consideration of approaches to rectify the issue.
Guidance around each of these areas is provided to help inform and shape the
assessment and actions arising from the rationale for intervention.
3.2. Identifying the issue
Any identification of the issue to be addressed should start with a review of the
evidence base. This is about identifying the specific reasons around the need
for intervention (before full consideration of the precise rationale for
intervention). This could include consideration of an opportunity, addressing
issues around co-ordination problems or be based on institutional failures.
However, the key is that these should be explored so that there is a clear
understanding of the reason for intervention.
Therefore a review of the evidence should consider:

What is the issue?

What is the evidence for the issue?

What is the scale (or severity) of the issue and how has it changed over
time?

Why does the issue arise?
A key process at this stage is to understand the issue and ask ‘why?’, and
continue to ask ‘why?’ until the fundamental reasons for the problem has been
identified. The key aim is to identify the root cause of the problem rather than
an intermediate reason.
9
Scotland’s poor national and international positioning on R&D is a good
example. The two main barriers cited by companies to R&D are cost and risk8.
However, cost and risk are not reasons in their own right, they represent lack of
information on success rates, market penetration and scale of returns. If these
were known with any certainty then there would be little risk and the return
would either be acceptable relative to the outlay leading to action or not would
be judged to be unacceptable leading to other activity. In effect those involved
would have the information needed to enable them to make rational decisions
as to whether to undertake R&D investment. Information issues are therefore
the main reasons for lack of investment.
By clearly identifying the problem and the evidence around it, it becomes
possible to move on to the next step – to assess the broad rationale for
intervention.
3.3. Assessing the broad rationale for intervention
Once the issue has been identified and defined, it is possible to move towards
a definition of the rationale by assessing the issue in the light of high level
questions around the rationale for intervention. Diagram 3.1 provides the core
questions to be asked to link the problem to a specific rationale (or combination
or rationales) for intervention.
8
Frontline Consultants (2009) Evaluation of the R&D Grant, Scottish Enterprise
10
Diagram 3.1: Exploring the Rationale for Intervention
Rationale for
Intervention
Equity
Does Scotland or
groups within Scotland
compare poorly
relative to other places
or groups? (such as
lower levels of R&D)
Imperfect
Information
Is this lack of
information likely to be
evident across all
participating parties?
Asymmetric
Information
Will one party have
greater access to the
information than
another in the activity?
Moral Hazard
Will individuals
in a contract
have an
incentive to
behave in a
negative manner
not expected pre
contractually?
Adverse
Selection
Will the buyer of
a good / service
have more
information than
the seller
resulting in an
inefficient
outcome?
Efficiency
Are there
imperfections or faults
(such as low
productivity) in the
market that can only
be resolved with public
sector intervention?
Externalities
Are there likely to be
wider costs and
benefits not
considered in the
decision making
processes of potential
beneficiaries?
Information Failure
Are there likely to be
issues around lack of
information in potential
beneficiaries?
Market Power
Is there a lack of
competition in the
market leading to
inefficient prices and
quality/quantity of
goods or services?
Public Goods
Would the market
have difficulty
providing the good /
service because
consumers cannot be
excluded from using it
and cannot be made
to pay for it?
Environment
Is there scope for the
intervention to lead to
positive environmental
impact or reduction in
harmful impacts in line
with government
priorities?
Positive Externalities
Are there likely to be
more positive wider
benefits than negative
wider effects?
Negative
Externalities
Are there likely to be
more negative wider
effects that positive
wider benefits?
Wider reasons for
intervention
Institutional Failure
Has there been wider
public sector
intervention that
requires subsequent
action to correct
unintended effects?
Co-ordination Failure
Is it impossible for all
parties involved in a
transaction to to reach
agreement on a
desired course of
action?
Opportunity
Is there an opportunity
that requires public
sector intervention to
access or pump
prime?
11
3.4. Exploring the rationale in more detail
Once the particular broad rationale (or rationales) for intervention have been
identified, it is important to investigate the issue further to assess the extent to
which there is justifiable and clearly defined evidence (rather than anecdote) to
support the rationale for intervention.
The evidence should be based on
research, appraisal or evaluation work. An example of this is in a recent piece
of research work around ICT which explored the reasons for intervention –
including the expected market failures, by examining the issue theoretically,
then testing the theory with SE staff and companies9.
The subsequent sections consider these specific questions associated with
each of the areas covering:

Efficiency rationales – with key questions articulated in section 4 and
examples provided in Appendix 1 and 2 under the key areas of Scottish
Enterprise activity to understand and evidence market failure

Equity rationales – with key questions articulated in Section 5

Environment rationales – with key questions articulated in Section 6.
By exploring the specifics of the rationale in more depth, it will be possible to
develop a strong strategic case underpinned by a clear and evidenced
rationale for intervention.
3.5. Considering approaches to rectify the problem
Once the rationale (or rationales) for intervention have been identified and
evidenced, there is need to consider the most appropriate Scottish Enterprise
activities that will help to overcome the failures, help even up outcomes or lead
to positive environmental outcomes.
While this is covered in the wider project or programme development process
around the development of the strategic, economic, commercial, financial and
management cases, it is important to make appropriate linkages between the
rationale for intervention and the activities proposed.
Scottish Enterprise intervention can take a number of forms, each with different
strengths and weaknesses depending on the underlying rationale.
The
9
SQW Consulting (2009) Research to Inform ICT Business Support Interventions,
Scottish Enterprise
12
diagram below outlines the typical broad intervention types as well as the
extent to which these have been assessed as being effective at addressing
specific market failures.
Diagram 3.2: Linking the Rationale with Activities10
Intervention Area
√√
Information, Education
and Advice
Key SE interventions
 Provision of
information
 Campaigns
 Reporting and
disclosure
requirements
 Advisory services
 Representation
services
Direct intervention
Key SE Interventions
 Direct provision of
service
 Commissioning of
services
Intervention Area Likelihood of Success
√ Low likelihood of addressing the failure
√√ Medium likelihood of addressing the failure
√√√ High likelihood of addressing the failure
Information failure
√√
Information failure
Externalities
√
Externalities
√
Economic instruments
Key SE Interventions
 Grants
 Loans, loan
guarantees
Wider Government
interventions
 Subsidies and
vouchers
 Taxes
 Charges
 Tradable permits
 Awards
Regulation and
legislation
Wider government
interventions
 Price and market
structure regulation
 Production and
consumption
regulation
 Standards setting
 Prescription and
prohibition legislation
 Rights and
representation
Information failure
√
Information failure
√√
Externalities
Market Power
√
Market Power
√
Market Power
√√ √
Externalities
√√
Public goods
Public goods
√
Public goods
√
Market Power
√√
Public goods
√
10
Diagram developed from information in Ledbury.M, Miller.N, Lee.A, Fairman.T and
Clifton.C (2006) Understanding Policy Options, Home Office Online Report 06/06.
13
It should be noted that these cover general guidance, and that specific
approaches can be used on a case by case basis subject to appropriate
justification as to why the proposed activity is likely to overcome the specific
failure. The key is ensuring that the solution is likely to remove or alleviate the
barrier and lead to the desired outcome.
The intervention areas also cover a number of areas not directly relevant to
Scottish Enterprise (which does not have a direct role in the setting of
legislation or regulations for example), but are intended to highlight how
particular problems can or could be addressed.
14
4. Efficiency Rationale
4.1. Background
Efficiency rationales are focused on correcting failures in the market that
somehow lead to inefficient outcomes. Outcomes are deemed to be efficient
where the benefits of intervention exceed the costs of the intervention. As
outlined earlier this is based on a more reasoned view that no market will ever
be perfect, but that intervention should be balanced on the ability of the activity
to overcome the problem and deliver benefits at a higher level than any costs
of the activity.
There are four market failures as outlined in the HM Treasury Green Book
covering:

Information failure

Externalities

Public goods

Market power.
Each of the four main failures is assessed in turn, outlining key questions to
check for their existence11. The details for each of these should be used to
flesh out the detail of the project or programme rationale identified earlier. It
should be noted that the first two failures around information and externalities
are likely to be most relevant to Scottish Enterprise, with the remaining two less
likely to be relevant except in very particular cases.
4.2. Information failure (imperfect information)
Imperfect Information refers to a situation where individuals are not perfectly
informed about the options available to them. This can include situations in
which the information is available but the individual cannot process the
information accurately.
11
These are based on questions developed in Ledbury et al (2006) Understanding
Policy Options and OffPAT (2009) OffPAT Advice Note 1/2009, The Rationale for
Public Sector Intervention: In Economic Development and Regeneration Programmes
and Projects
15
Again, this relies heavily on the notion of ‘perfect’ information. However, it is
unlikely for any company or individual to be perfectly informed about all the
options available to them. As such it is about extremes where there are clear
gaps in information that are detrimental to decision making where Scottish
Enterprise would be best placed to intervene.
Equally with the internet and continued improvements in global information
sharing it is difficult to understand a position where a company cannot at least
access a sufficient level of information to make a decision. However, there are
issues where companies can become path dependent, or behave in ways in
which they have always behaved. This highlights that it is not always about the
availability of information, but the willingness and/or ability of individuals to
process information in ways that are useful to them.
Generally, where there is some sort of information failure it is not appropriate to
develop direct intervention mechanisms, but instead to either develop or
signpost to appropriate information, advice and guidance.
Key questions to identify Imperfect Information include:

What information is required to make a decision?

Is there demand for the information?

Is the information available?
o Does the market supply the information?
o What are the costs of the information?
o What are the benefits of the information?
o Can the information be accessed?
o What is the quality of the information?

Given the information are the individuals able to make the ‘best choice’
(or at least close to the ‘best choice’) with it?:
o Do individuals have the capacity to process the data?
o Are individuals likely to miscalculate the costs?
o Are individuals likely to miscalculate the benefits?
16

Are there differences in perceived costs and real costs?

Are there differences in perceived benefits and real benefits?
Examples of imperfect information

Lack of information on customers and their requirements in export markets
limits
Scottish
companies
from
investing
in
overseas
markets
(Internationalisation)

Lack of evidence on the potential returns from R&D limiting in house R&D
activity (R&D)

Lack of information on development sites limiting scope for investment in
new business premises (Infrastructure)
4.3. Information failure (asymmetric information)
Asymmetric Information refers to a situation in which one party in a transaction
is better informed than another. Again, there will always be situations where
there are elements of information asymmetry. However, it is where these are
acute and where they limit decision making where intervention would be best
targeted.
There are two further specific sub areas associated with Asymmetric
Information covering:

Adverse selection – where individuals enter into a contract but cannot
observe the type or quality of the good or service and are therefore
unwilling to pay the full price for the good or service (because they don’t
really know if they are getting something that is good or bad)

Moral hazard – where a contract or agreement actually increases the
probability of occurrences of what people are insured against (where a
company may be less cautious with money having accessed an
investment designed to develop a new product for example).
Key questions to identify Asymmetric Information:

Which parties are involved in the contract?

Is one party better informed than the other?
17

Is it possible for the uninformed party to access the required
information?

Is it too costly for the uninformed party to access the required
information?
Key questions to identify Adverse Selection:

Can the uninformed party distinguish between the type or quality of the
good/service?

Are there incentives or opportunities for the informed party to work
against the uninformed party?

Is it possible for the informed party to signal (such as quality marks,
accreditations or guarantees) to the uninformed party?
Key questions to identify Moral Hazard:

Can the uninformed observe the actions of the informed?

Are there incentives or opportunities for the informed party to act
against what was agreed in the contract?
Example of Asymmetric Information

Banks not lending to a new start company as the new start knows more
about their proposition than the bank making it difficult for the bank to price
a loan and therefore not providing funding (Enterprise)
Example of Adverse Selection

Companies being unable to separate good advice on business efficiency
from bad advice and therefore putting off activity altogether (Specialist
Advisory Services)

High transaction costs of diligence in equity investments leading to lack of
investment in smaller business propositions (Equity investments)
Example of Moral Hazard

A company in a research collaboration using partner knowledge to support
their own company’s wider product development separate from the contract
research they are involved in because they have access to the partner
18
companies intellectual property.
The company is essentially poaching
knowledge from the collaborative partner even though this had not been
envisaged when the collaboration agreement was signed (R&D and
innovation)
4.4. Externalities (spillovers)
Externalities (or spillovers) refer to a situation in which a particular activity
produces costs or benefits that are not directly priced by the market. This is
linked to the notion of the ‘perfect’ market where everything is priced.
However, in reality there are a number of grey areas where there is no price
(either in terms of rewards for ‘good’ activity or costs associated with ‘bad’
activity). This situation can cover:

Positive Externalities – where an individuals actions or behaviour
directly impact on others welfare (positively) and these actions are not
taken into consideration. Paradoxically positive externalities, as they are
not priced, are seen as examples of markets failing. Despite this they
may be something that public bodies may want to encourage. However,
the consequences of Positive Externalities is typically under provision or
under consumption

Negative Externalities – Where an individual’s actions or behaviour
directly impacts on others welfare (negatively) and these actions are not
taken into consideration. Negative Externalities typically lead to over
provision or over consumption
Key questions to identify Positive Externalities:

Which parties have an interest in the action or its impact?

What are the private costs and benefits from participation (tangible and
intangible)?

What are the social costs and benefits from participation (tangible and
intangible)?

Is there a difference between the private costs and benefits and social
costs and benefits?
19
o Are social costs less than private costs?
o Are social benefits greater than private benefits?

Who gains from the benefit of the externality?

Who incurs the cost of the externality?

Does the primary actor take into account the wider social costs and
benefits?
Key questions to identify Negative Externalities:

Which parties have an interest in the action or its impact?

What are the private costs and benefits from participation (tangible and
intangible)?

What are the social costs and benefits from participation (tangible and
intangible)?

Is there a difference between the private costs and benefits and social
costs and benefits?
o Are social costs greater than private costs?
o Are social benefits less than private benefits?

Who gains from the benefit of the externality?

Who incurs the cost of the externality?

Does the primary actor take into account the wider social costs and
benefits?
Examples of Positive Externalities

R&D investment is a positive externality as the firm undertaking the R&D
cannot capture all of the benefits of the investment, such as wider health
benefits associated with a new drug discovery (R&D)

Staff training is a positive externality as the firm undertaking training cannot
capture all of the benefits of the investment – such as productivity
improvements in a rival firm as a result of training at a previous company
Example of Negative Externalities
20

Developers not renovating dilapidated office space which reduces local
property values as there is no return to be made by the developer from the
investment (Local Regeneration)
4.5. Public goods
Public Goods represent a position where the market may have difficulty in
supplying and allocating certain types of products or services which society at
large demands. Accordingly there is justification for the public sector to
intervene. Public goods are less relevant from an economic development
perspective, as they tend to focus on areas such as street lighting or national
defence, but are included for completeness.
Key questions to identify Public Goods:

Is it non rival? In effect – consumption by one person does not prevent
someone else using or consuming that good

Is it non excludable? In effect – if it is made available to one consumer
is it effectively made available to all consumers.
If there is non excludability, problems of Free Riding can occur. This is a
situation in which consumers fail to pay for something because they expect
others will do so even through they still want to access the good or service.
Key questions to identify Free Riding:

Is it possible to enjoy the benefits of the good/service without having to
pay for it?

What incentives are there not to ‘free ride’?

Is there any evidence to suggest consumers will not free ride?
Examples of Public Goods

The public sector providing information on investment locations online to
attract inward investors (Inward Investment)

Developers not funding public realm developments as they cannot exclude
people from enjoying it and cannot make them pay for it (URCs)
21
Example of Free Riding

A retailer on a street not paying for litter to be cleared from the front of their
shop because the other retailers on the street pay for it (as well as their
own) to ensure they don’t put customers off and lose sales (Enterprise)
4.6. Market power
Market Power refers to a situation where there is a lack of competition in the
market leading to inefficient price or quantity. In such cases there is justification
for public sector intervention. Again, like public goods, market power is not as
relevant for economic development in its purest sense, as it would require the
existence of monopolies or cartels.
However, in the sense that large
companies can block the path of new starts to some extent it may have some
relevance in specific cases.
Key questions for identifying Market Power:

What is the market structure?
o Do firms have the power to control prices?
o How many firms are there?
o What is their market share?
o Are products differentiated?

Where the market is dominated by a single provider:
o Is the market contested (in effect is there a large number of
companies competing with each other)?
o Can potential competitors be identified?
o How high are the barriers to entry?
o How high are the costs of innovation?
o Does the monopolist behave in a competitive way (such as
keeping prices low to avoid competitors taking market share)?

Where there is a small number of firms in strategic competition:
o Can they benefit from co-operating?
22
o Are they colluding to prevent competition?
Example of Market Power

A large company has no direct competitors in an area and therefore
increases its prices to take advantage of the lack of competition (Enterprise)
23
5. Equity Rationale
5.1. Background
Equity rationales are focused on ensuring that there are efficient outcomes
across places or groups. This could include Scotland lagging behind other
nations in relation to productivity per head or through pockets of low economic
participation within Scotland relative to other places (two key strands of the
Government Economic Strategy).
Equity arguments are not easily separated from the more traditional market
failure rationales – as a gap between places or groups is likely to be the result
of market failures. However, they can be used on their own as the basis for
intervention, where the equity gap is large and has a serious implication for
economic performance. A good equity rationale will also try to explore what
the wider failures are that have resulted in the gap making reference to the
more traditional market failure arguments.
Equity arguments can be developed by comparing one group or area with
another or Scotland’s economic performance with that of other regions or
countries.
This could include benchmarking performance using official
statistics or through ad hoc primary research.
5.2. Key questions to identify equity rationales
Some key questions that could be explored in order to build up an equity
rationale could include

What is Scotland’s position relative to other areas (such as English
regions, EU countries, OECD nations or arc of prosperity countries)?

Are there other similar indicators that reinforce or weaken the evidence
(such as using the employment rate and decline in employee jobs to
highlight weak economic performance)?

How has Scotland’s position changed over time?

How has Scotland’s position changed over time relative to other places?

What is the gap between Scotland and appropriate benchmarks?
24

How has the gap between Scotland and appropriate benchmarks
changed over time?
The key in developing equity rationales is the use of primary and secondary
evidence to profile the position of Scotland or the particular group and the
dynamics over time.
Equity Argument Example

Variations in economic performance across Scotland has resulted in the
designation of assisted areas, or areas that, on a range of economic
measures, lag behind the Scottish average.
The Regional Selective
Assistance scheme is an example of a response to this gap, with funding
directed at companies either located in or considering locating in an
assisted area
25
6. Environment Rationale
6.1. Background
Environmental arguments are a special case in the rationale for public sector
assistance. They represent a mix of efficiency and equity failures. However,
the increased national and international focus on environmental objectives
means they warrant a special case as a separate rationale for intervention.
6.2. Key questions to identify environmental rationales
The key to evidencing environmental rationales is to consider:

If activity will have relatively immediate positive direct environmental
impacts (either improvement of the environment or reductions of
negative impacts) – essentially impacts arising directly from the
activities

If activity will have relatively immediate positive indirect environmental
impacts (either improvement of the environment or reduction of negative
impacts) – essentially impacts arising in the wider supply chain
associated with the intervention area

If activity will fit with key government policy priorities in relation to the
environment (such as support for renewable power generation)

If the activity will make a contribution to government purpose targets
around the environment (such as the reduction in emissions over the
period to 2011).
By answering these questions it will be possible to develop an environmental
rationale for intervention.
Environment Argument Examples

High levels of carbon created from electricity generation at traditional power
stations producing high levels of emissions

High levels of scrap metal waste at a manufacturing plant could be seen as
having a negative environmental impact
26
7. Presenting the Rationale for Intervention
Once the rationale (or rationales) for intervention have been assessed, refined
and evidenced it is important that the information is conveyed appropriately.
This means a strong structure should be used to present the underlying
rationale and consideration. A suggested structure is:

What is the issue that needs to be addressed – a short description of
the issue and the evidence in support of it

What is the rationale (rationales) for intervention – a description of how
the rationales have been arrived at, backed up with answers to the
specific questions that make up each rationale underpinned with clear
evidence

Outline the proposed solution – this should consider the activity
proposed and how this will overcome or alleviate the issue to be
addressed.
27
8. Summary and Checklist
This guidance document has outlined a set of key steps to be followed in
developing a rationale for intervention for new projects or programmes
brought forward for funding.
The key point is that understanding the rationale for intervention should be
the first step in the development of any public sector intervention.
The
rationale for public sector intervention falls into one of three main t areas:

Equity – intervention to ensure the even distribution of outcomes
(across groups or places), or the achievement of wider social objectives
(such as the participation strand of the Government Economic Strategy)

Efficiency – intervention to ensure the achievement of economic
objectives by addressing inefficiencies in the market: the classic market
failure arguments. These include:

Information failures – failures associated with lack of
information leading to inefficient outcomes

Externalities – wider positive or negative effects not felt by
the originator of the activity that lead to over or under use of
a particular activity

Public goods – failures associated with activities which it is
impossible to produce for private profit

Market power – the position where an organisation controls
the market in a way that is not competitive and where output
is restricted as a result.

Environment – intervention for sustainability, either through the
reduction of harmful environmental impacts or maximisation of positive
environmental impacts (this is actually a special case of efficiency and
equity objectives, but deserves consideration in its own right due to the
current high policy focus on the environment and sustainability).
28
The rationale should be clearly evidenced and used to understand how
particular interventions could help to overcome the failure and do so in a way
where the benefits of intervention will exceed the costs.
This final table provides a checklist of the key steps and should ensure the full
process for developing the rationale for intervention has been fully completed.
Table 8.1: Final Rationale for Intervention Checklist
Step
Key activities
Section in the guidance
1
Understand the problem
Section 3
2
Identify the broad rationale area Section 3
(or areas)
3
Explore
the
rationale
(or Sections 4, 5 or 6 (supported by
rationales) in more depth
4
Appendices 1 or 2)
Consider approaches to rectify Section 3
the problem (or problems)
5
Present
the
rationale
(or Section 7
rationales)
Appendices 1.1-1.7 and 2.1-2.3 provide some illustrations and examples of
the types of activity or implications that might provide some evidence around
market failure associated with a number of core areas of Scottish Enterprise
activity. These are not definitive, nor are they evidence in their own right, but
represent potential areas for further exploration to try to understand some of
the types of failure or activity that may signify market failure associated with
key Scottish Enterprise interventions.
29
Appendix 1: Growing Globally Competitive Business
Appendix 1.1:
Internationalisation Examples
Appendix 1.2:
Inward Investment Examples
Appendix 1.3:
Enterprise Examples
Appendix 1.4:
Account Management Examples
Appendix 1.5:
Specialist Advisory Support Examples
Appendix 1.6:
Commercialisation Examples
Appendix 1.7:
R&D and Innovation Examples
30
Appendix 1.1:
Internationalisation Examples
Market Failure
Illustrations of the failure
Typical SE response
Positive
Companies not taking forward activity which

Market advice
Externalities
means there are no positive demonstrations

Exporting advice

Trade missions
no demonstration effect of exporting

Learning journeys
No technology transfer or spillovers from

Financial support
of the benefits of exporting
No stimulation of local competition as there is
engaging with overseas firms as a result of
low levels of activity in this area
No scope for labour mobility (between
domestic and overseas companies) as there
is little activity in this area
Imperfect
Lack of understanding of the price and quality

Market advice
Information
of overseas goods

Trade missions

Learning journeys

Exporting advice

Financial support
Lack of information on connections – identity
and location of suppliers
Lack of information on target markets –
identity and location of customers
Lack of understanding of cultural issues,
routes
to
market,
overseas
regulatory
systems and intellectual property protection
frameworks relative to the home country
Lack of skills and knowledge in SMEs to take
activities forward
Lack of information on returns relative to non
recoverable costs
31
Asymmetric
Limited domestic knowledge in comparison

Market advice
Information
with overseas companies limiting activity

Trade missions
Firms with little collateral or track record not

Learning journeys
equity funding for overseas expansion leading

Exporting advice
to limited activity

Financial support

Scottish
having enough evidence to access debt or
Moral Hazard
Parties have difficulty in verifying if the
contract is being fulfilled due to distance
between
headquarters
and
overseas
suppliers or customers
Adverse Selection
Challenge of proving quality with no local
presence or track record
Public Goods
The provision of unique and impartial advice –
on international markets and contacts
Development
International
32
Appendix 1.2:
Inward Investment Examples
Market Failure
Illustrations of the failure
Public Goods
Provision
of
information
Typical SE response
on
the

domestic market to potential investors
Marketing
of
specific
Scottish
Development
International
investment
locations to overseas companies
Positive
No productivity growth in domestic firm
Externalities
suppliers and competitors due to lack of
inward investors

Development
International

Little or no collaborations / networking
opportunities with domestic firms due to
Scottish
Regional
Selective
Assistance

R&D Grants

Training Plus

Scottish
a lack of inward investors
Loss of capital inflows from parent
companies due to
a lack of inward
investors
No or limited knowledge transfer to
domestic firms due to small numbers of
inward investors
Imperfect
Lack of knowledge on investment
Information
locations
Development
International
Lack of knowledge in risks and returns

from locations
Regional
Selective
Assistance
Lack of local contacts for supply or

R&D Grants
support

Training Plus
Lack of knowledge on cultural issues,
domestic
intellectual
frameworks
regulatory
systems
property
relative
to
and
protection
the
home
country
33
Appendix 1.3:
Enterprise Examples
Market Failure
Illustrations of the failure
Information
Lack of understanding in terms of
Failures
finding, accessing and securing finance
Typical SE response

development
workshops
Lack of understanding of customers and
markets

Support for high growth
firms
Lack of understanding around premises
and recruitment

PSYBT
Lack of awareness of entrepreneurship

Entrepreneurship
as an option
Asymmetric
Potential financial overstatement of risk
Information
by investors / lenders
Potential lack of individual track record to
education

SEED Fund

Investor

workshops

pitches
High transaction costs associated with
assessment of market opportunities
Business start up and
development
Limited investor readiness in terms of
packaging the opportunity or making
readiness
support
justify investment
Adverse Selection
Business start up and
Support for high growth
firms

PSYBT

Entrepreneurship
Difficulty in separating good advice from
education
bad advice on starting up a business
Positive
Loss of wider supply chain benefits due
Externalities
to low numbers of new starts
Loss of customer benefits (better product

Investor
support

Business start up and
range / cheaper products) due to lower
development
numbers of business starts
workshops
Loss of wider development or start up

culture / demonstration effect due to low
levels of business start up
readiness
Support for high growth
firms

PSYBT

Entrepreneurship
education
34
Appendix 1.4:
Account Management Examples
Market Failure
Illustrations of the failure
Typical SE response
Imperfect
Limited understanding within businesses
Information
of the range of key skills needed for
business growth – including e-business,

management
sustainable
growth,

products
One to one strategy or
business improvement
development,
strategy
to
(Strategy, R&D, etc)
innovation, internationalisation, leadership
and
Access
support
and
organisational development

Access to finance

Access
Lack of information on the likelihood of
success
to
business
improvement
investment
Lack of information on returns relative to
non recoverable costs of activity
Limited awareness of where to access
support across all business areas
Limited awareness of the benefits arising
from support
Asymmetric
Difficulty of understanding where to
information
access information
Adverse Selection
Difficulty separating good advice from
to
products
(Strategy, R&D, etc)

bad advice limiting activity
One to one strategy or
business improvement
support

Access to finance
35
Appendix 1.5:
Specialist Advisory Support
Market Failure
Illustrations of the failure
Typical SE response
Imperfect
Firms recognising problems, but not

SMAS
Information
having the knowledge to understand

Access
what to do to address the problem
to
products
(Strategy, R&D, etc)
(small firms)

Firms knowing what to do about
One to one strategy or
business improvement
problems but not being able to make the
support
case to management due to uncertainty
of benefits (large firms and inward

Access to finance
investors)
Lack of understanding of specialist
areas and how to do the right thing (e.g.
marketing)
Lack of understanding of the benefits
from specialist skill areas – such as
marketing, strategic development or
business efficiency
Limited competency in businesses to
accurately
process
information
on
specialist areas
Limited competency in business to plan,
manage
and
execute
projects
in
specialist areas
Asymmetric
Difficulty of understanding where to

SMAS
information
access information

Access
Adverse Selection
Difficulty separating good advice from
bad advice limiting activity in key
to
products
(Strategy, R&D, etc)

business areas
One to one strategy or
business improvement
support

Access to finance
36
Appendix 1.6:
Commercialisation
Market Failure
Illustrations of the failure
Imperfect
Lack of information on commercialisation

Foresighting
information
(from

Account management

Prospekt
ownership

Bioquarter
Lack of information and ability to develop

Enterprise Fellowships
an effective management team

Industrial Fellowships
Lack of information and ability on proving

Proof of concept
the
academic
Typical SE response
and
business
communities)
Lack of information or clarity on IP
the viability of products
Lack of information and ability around
generating investment
Lack of information and ability to explore
routes to market
Insufficient information on costs and
benefits of acquiring information
Insufficient awareness
of
where
to
source information on the costs and
benefits
of
commercialisation
(for
academics and businesses)
Lack of awareness of expertise in
universities / knowledge providers – in
the business base and in the promotion
of the expertise
Lack of information on how to access
and
use
university
knowledge
in
businesses
Uncertainty of future financial return
associated with commercial propositions
– scale of return
Uncertainty of future financial return
associated with commercial propositions
– timing of return
37
Inability of companies to exploit the
presence of leading edge technology –
opto-electronics,
e-commerce,
biotechnology
Positive
Lack of investment in commercialisation
Externalities
due to fear of poaching (ideas or staff)
Loss
of
social
benefits
from

Intellectual
Assets
centre
new
technology / products due to limited
activity around commercialisation
Asymmetric
Lack of signals from universities of the

Prospekt
information
benefits of commercialisation

Bioquarter
Lack of signals from businesses of the

AFRC
benefits of commercialisation
Lack of signals from businesses on
openness to universities
Lack of signals from universities on
openness to businesses
38
Appendix 1.7:
R&D and Innovation
Market Failure
Illustrations of the failure
Typical SE response
Imperfect
Lack of understanding of market size, routes

R&D Grant
information
or penetration

Innovation Support
Lack of understanding of detailed technical
specifications
Service

Lack of understanding of costs – overheads,
staff,
equipment,
materials,
Innovation Support
Grant
external
knowledge
Lack of specific market information for
decision making
Lack of staff ability to process information for
planning or decision making
Lack of understanding of market launch
activities
Lack of understanding of failure rate for R&D
/ innovation
Lack of access to information to aid decision
making
Poor quality of information on R&D /
innovation costs and benefits
Difference between real and perceived costs
and benefits of accessing information
Asymmetric
Companies unable to access finance due to

R&D Grant
information
lender/funder

Innovation Support
uncertainty
of
the
likely
success of R&D innovation activities
Lenders
unable
to
understand
Service

technical/innovation elements of propositions
Innovation Support
Grant
resulting in loss of investment
Lenders unable to understand market scale,
scope, routes and likely penetration resulting
in loss of investment
Positive
Loss of activity due to fear competitors will
Externalities
benefit from new ideas

R&D Grant
39
Limited activity due to company fears around
loss of staff / ideas to competitors

Innovation Support
Grant
Loss of demonstration effect of R&D /
innovation as companies cannot capture
social benefits
Limited activity due to fear of reverse
engineering
of
new
products/processes/services
Limited activity due to fear that abandonment
of research shows competitors areas not to
pursue
Limited activity due to a fear patenting will
open up routes for competitors to understand
new technology
Limited activity due to fear that new
Innovations show the potential size of the
market or opportunity to competitors
40
Appendix 2: Globally Competitive Business Environment
Appendix 2.1:
Business Infrastructure
Appendix 2.2:
Equity Investment
Appendix 2.3
Local Regeneration / Urban Regeneration Companies
41
Appendix 2.1:
Business Infrastructure
Market Failure
Illustrations of the failure
Typical SE response
Imperfect
False perceptions of remediation costs

Infrastructure
investment – property
information
development
Limited information on financial returns –
scale of return

URCs

Infrastructure
Limited information on financial returns –
timing of returns
Co-ordination issues around activities
and resources
Low
awareness
of
investment
opportunities
Uncertainty of disposal process
High uncertainty of costs and benefits
for specialist accommodation
Positive
Loss of environmental improvements
Externalities
from clearing derelict or contaminated
investment – property
land due to lack of private sector ability
development
to gain financial benefits from the

Streetscaping

URCs
investment
Private sector not developing sufficient
scale to ensure a place is internationally
competitive or attractive with a loss of
wider economic value
High
cost
of
social
returns
from
infrastructure not costed in private
developer plans – e.g. coastal defence,
utilities, new roads
Loss of amenity development in place
through redevelopment due to lack of
private sector ability to gain financial
benefits from the investment
Loss of catalyst effect due to fears by
developers that other competitors will
take on benefits from their own initial
42
investment
Public Goods
Provision of core utilities and public

Streetscaping
realm

Infrastructure
investment

Property maintenance

URCs
43
Appendix 2.2:
Equity Investment
Market Failure
Illustrations of the failure
Imperfect
Lack of understanding of finance options

Investment funds
information
available to companies

Investment readiness
Lack
of
understanding
Typical SE response
of
funder
requirements
support

Portfolio investments
Lack of capability to present to funders
Lack of capability in due diligence
Asymmetric
Investors not aware of wide range of good

Investment funds
information
opportunities

Investment readiness
Investees not aware of their lack of
investor readiness
support

Portfolio investments
Companies unable to access finance due
to lender/funder uncertainty
Lenders
unable
technical/innovation
to
understand
elements
of
propositions
Adverse Selection
High transaction costs associated with
due diligence
Negative
Dominance of large enterprise at the

Investment funds
externalities
expense of smaller companies

Investment readiness
Dominance of established enterprise at
the expense of new companies
support

Portfolio investments
Important new starts not funded – with
corresponding loss in economic and
social value
44
Appendix 2.3
Local Regeneration / Urban Regeneration Companies
Market Failure
Illustrations of the failure
Imperfect
Lack of development history acting as
information
an inhibitor for investment
Typical SE response

investment – property
development
Lack of evidence on rent / yield rates
Perceived and real costs of accessing
Infrastructure

URCs

Infrastructure
site information relative to real and
perceived benefits
Lack of understanding of time, quality
and scale benefits from investment
Lack of information in small businesses
due to size and limited time for research
work
Positive
Loss of potential reduced congestion
Externalities
through new transport infrastructure due
investment – property
to lack of a private return
development
Loss of environmental quality through

URCs

Infrastructure
limited investment in site remediation
Commercial appraisal process doesn’t
capture wider value from development
Public goods
Perception public spaces should be
provided – especially when they don’t
investment – property
generate any direct financial return
development
No clear incentive for private sector due

URCs

Infrastructure
to communal use of public space –
streetscape and public realm
Market power
Large firms present a barrier to entry for
investment – property
smaller firms
development
Fear of large firms stifles growth of
smaller or less established players

URCs
45