home | strategy development | strategy skills | site index | access keys

Strategy Skills > Appraising Options

Rationale for government intervention

> in practice

Identifying the rationale for government intervention is crucial to deciding when - and in what ways - governments need to get involved.

The current draft of the HM Treasury Green Book identifies two basic justifications for government intervention:

• The enhancement of economic efficiency by addressing problems with the operation of markets and institutions
• The achievement of a social objective, such as promoting equity.

The existence of a problem does not in itself justify government intervention. Government itself does not function perfectly, and any form of government intervention may impose costs. This means that even when markets do not work effectively to deliver desirable goals, government must compare the costs of failing to deliver those goals against the potential costs of the intervention.

There are four key stages to justifying the rationale for government intervention:

1. Identify the set of policy goals to be achieved
2. Identify why these goals may not be delivered without government activity
3. Identify what actions are available to government in order to deliver the desired outcomes
4. Consider whether the costs of government intervention are justified.

1. Identify the set of policy goals to be achieved:

This involves an assessment of the Government's strategic goals and objectives, and the way in which they are translated to individual policy areas.

2. Identify why these goals may not be delivered without government activity:

Economists identify two broad types of reason why government activity may be required:

(I) Market failure, of which there are several types:

• Imperfect competition (market power). Economic theory demonstrates efficient outcomes will be delivered only where markets are actually or potentially competitive. As soon as there is an element of monopoly (on the side of the seller) or monopsony (on the side of the buyer) power that can be exercised, a less efficient outcome will occur. This may arise because of the natural characteristics of the market (e.g. very high costs of entry) or through strategic behaviour by incumbents (e.g. predatory pricing).
  
  
• Externalities. Externalities result when a particular activity produces benefits or costs for other activities that are not directly priced into the market. When this happens, the amount of the particular activity that takes place will generally be inefficient. Externalities can be "positive" or "negative". An example of a positive externality is the spill over effect into other areas that can occur as a result of research and development activity. A company or research institution will generally decide its level of R&D on the basis of the benefits that it can capture - ignoring benefits that might occur elsewhere. An example of a negative externality is pollution of the environment. A company or individual may reduce its own costs by failing to implement pollution controls, but this will generally impose costs on those affected by the pollution.
  
  
• Information failures. The effective operation of markets relies on the fact that all the participants in the market have complete and perfect information relevant to that market. When this information is not available to all participants, this is described as asymmetry of information, and market failure can arise. Information asymmetries lead to sub-optimal outcomes. For example, a buyer may not have full information on the characteristics of a product or service he/she wishes to buy - this is known as adverse selection.
  
  
• Public goods. Markets work effectively to provide private goods and services, which are typically rival and excludable in nature - i.e. each specific item or service can only once be sold/bought, and once purchased, can be exclusively "enjoyed" by the purchaser. In contrast, public goods and services are non-rival and non-excludable - if one person purchases the good or service, that does not stop others from purchasing it; and there is generally no way to stop people from enjoying the good or service. True public goods and services are comparatively rare, but the provision of national defence and of law and order are typically used as illustrations.

(II) Equity, which is to do with the delivery of social or distributional objectives. Even where markets are working efficiently, they may result in a distribution of income (or other benefits/costs) that is unacceptable to society. This will often arise through a lack of incentives to improve equity, or because the necessary information is available only to government.

3. Identify what actions are available to government in order to deliver the desired outcomes:

As well as providing a useful checklist for justifying government activity, the issues outlined above can also be helpful in pointing towards the type of activity that government might want to undertake - Stage Three of the process. Government intervention should typically be directed at tackling the particular market failure that is occurring, or at delivering the specific social objective in question. A wide range of interventions is available to government, and it will often be appropriate to consider several options. Examples include tax incentives, grants, loans, and information campaigns.

4. Consider whether the costs of government intervention are justified:

There are two separate aspects to this stage of the process:

• The first stage is to identify the additional benefits that would arise as a result of government intervention. The concept of additionality is important - what should be measured is not the gross benefit, but the benefit net of what would have happened without intervention.
• The second stage is to identify the negative impacts of the Government intervention. These negative impacts may include the direct costs of the intervention, but they may also include further negative impacts arising as a result of "government failure" - i.e. it is possible that government will get its intervention wrong, or that the intervention will have unintended consequences.

Only if the net benefit of intervention outweighs the costs of intervention is government action justified. In practice, this stage of the process may form part of the economic appraisal of the options for intervention, either through cost-benefit/cost-effectiveness analysis or through multi-criteria analysis.

Strengths

Using this four stage process - and in particular the list of market failures - is a good way of checking whether or not government should be involved in an issue.

Weaknesses

If applied incorrectly, the approach does contain pitfalls. For example, it is important to be sure that the net benefits of government intervention justify the costs. And even if an individual intervention is justified, it is also necessary to consider the overall burden imposed by government intervention - there may be a case for focusing intervention only on priority policy areas, so as to avoid "micro-management".

References

Micro-economics or public economics text-books include chapters on the basic market failures and how they should be dealt with.

HM Treasury Green Book and HMT micro-economics courses

For further material, see the Rationale for Government Intervention in Delivering Public Services

  top