Business- market failure

final yr


Potential exam questions:

Q1) Using market failure based arguments, make the case for providing free advice to young unemployed individuals.

¢This question asks students to initially distinguish market failure from political economy justifications for intervention.

¢Weaker students will fail to establish this important distinction. Weaker students will also fail to discuss the international evidence on the market failure based interventions to support younger people. ¢Stronger students will not only cover these issues but also point out the importance of policy choices faced by the policy maker (e.g. free/rationed support). ¢Better students will also touch on the ways in which any such policy intervention may be monitored/evaluated.

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Potential exam questions 2

Q2. Using market failure based arguments, make the case for providing free advice to all young people considering starting a business.

¢Strong students will begin by referring to market failure – in this case imperfect information – but also possibly external benefits and spillovers. ¢ ¢The market failure case is that young people are not fully informed about their entrepreneurial skills and that if free advice were provided this would encourage more of them to consider entrepreneurship as an occupation. ¢ ¢The external benefits of this would be to generate more entrepreneurship and possibly raise welfare in the economy. ¢ ¢The better students would review the evidence-base for all these assumptions.

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Why support SME's?

- Birch 1979 argued it is small firms that create jobs (NB: some more than others i.e. gazelles)

- Small firms are better innovators in some sectors and have behavioural advantages in that they can react to change quicker

- SME's contribute enormously to economic development as they improve what they offering in order to compete with new entrants and some do have the ability to grow very quick in order to contribute significantly to society. This is why governments are keen to maximise the benefits of:

1) more employment

2) higher GDP

3) maximise small business sectors

- Small firms are a productive outlet i.e. people can be as entrepreneurial as they want and this encourages a shift from a dependency culture to an enterprise culture. Social change=social entrepreneurs. 

- Political advantages: government needs to keep constitutencies happy because these are the people who vote them in or out!

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Market failure vs. political economy justification

- DISTINGUISH between MARKET FAILURE arguments AND POLITICAL ECONOMY justifications for intervention. 

- International evidence on market failure based interventions to support younger people

- Importance of policy choices fased by the policy maker i.e. free/rationed support 

- Monitoring and evalutation of policy intervention = important

NB: Almost every government in the world provides support for SME's and entrepreneurs (Hoffman 2007). 

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1st: Market Failure intervention

There is a case for intervention via government policy if there is market failure because:

- Contributions to economic development: but SME's make this independently of government?

- Failures in the market: MF def= inefficient allocation of resources/supply+demand=not equal. 

- Lack of competition (e.g. oligopoly): i.e. BIG 6 energy providers, dominate the sector and create barriers to entry for smaller firms. Intervention needed to level the playing field? Sectors too hard to enter not good for the market so policies and other regulation introduced. (Johnson 2005).

- Information imperfections/asymmetry (e.g. young people ignorant of benefits of entrepreneurship): government believes high rate of youth unemployment so to get out of the situtation set young up with skills to compensate for information imperfections. 

- Presence of externalities (demonstration/learning, knowledge spillovers): X student acts as role model for how to be a successful entrepreneur=external. Small firm clusters help each other with knowledge externally=creates benefits for other firms located within their proximity. Erasmus for Young Entrepreneurs=exchange programme for new2learn from experienced, EU funded. 

- Necessary but not sufficient to show market failure, benefits must also outweigh compliance costs of intervention (total benefits > costs): very debated in literature.

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2nd: Political Economy Approach

- A second theory/justification that is important for governments to explain their intervention policy is the political economy approach because:

- i.e. South East doing well but North of England not. Government will intervene. An imbalance between individuals in order to distribute and generate wealth more equally.

- BUT, politicians and public sector workers have their own vested interests (bureaucracy): they want to be re-elected which is their focus and purpose. They must do enough to be re-elected. Thus, short-term policies are attractive to further this purpose as they are quick and produce quick results.

- Power relations, pressure groups and ideology emphasis on enterprise sector and making people less independent (=the ideology). Making people less independent means in real terms just benefiting the large corporations. Should we be dependent on large firms though and on the state? Those who benefit really is those who have the power and we do not have any power to change things. Large firms can efficiently lobby the government. Small firms are diverse and heterogeneous sector which are not the beneficiaries of government policies because small firms are not really there to protect the governments interests per se. In the UK, we have a Federation for Small Businessess, which is not very influencial as the larger firms.  

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OECD framework

- All governments have policies for small firms, but it depends on the resources available to support small firms. Government looks into a set of determinants in relation to the culture and firms capabilities, by improving these, will be able to improve performance in these firms too. The better the small firm performs=the more impact on society (i.e. employment, GDP etc).

- Six OECD determinants = different areas when governments can intervene. Improve determinants= improve performance = impact on society jobs, GDP etc. 

1. Regulatory framework (administrative burdens for entry/growth, court/legal, tax, bankruptcy)

2. R & D and technology (invenstment for R&D, university interface, technology diffusion, internet)

3. Entreprenuerial capabilities (training, skills, immigration) 

4. Culture (risk attitude, desire for business ownership, education for mindset changes)

5. Access to finance (debt finance, business angels, VC acess, stock markets etc.)

6. Market conditions (competition, foreign market access, public involvement etc)

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South Africa case study

- 35% unemployment rate in South Africa = very high. 

- Entrepreneurship has become key within the school cirriculum and being taught to create their own work due to lack of grad jobs. Equipping students with entrepreneurial skills is helping combat unemployment issues. Increased media coverage i.e. The Apprentice has helped this to improve awareness of the value of entrepreneurship. 

South Africa utilising some of the below determinants of OECD:

3. Entreprenuerial capabilities (training, skills, immigration) 

4. Culture (risk attitude, desire for business ownership, education for mindset changes)

- So as to reduce poverty, create jobs and economic growth and distribute wealth more evenly. 

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1st OECD determinant: regulatory framework

-Regulatory institutions consist of laws, regulations, and government policies that promote certain behaviours and restrict others (Busenitz et al., 2000).

- The admin procedures necessary to start up a business vary from country to country:

a) Developed countries = more easier to set up as they want to make sure it is as easy as possible and with the least unneccesary admin work that create barriers and costs.

b) Lesser developed countries: regulations are very unstable in that the regs change frequently, cost losts and lots of corruption.

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World Bank Doing Business 2012 data

- World Bank data 'Doing Business' 2012: The regulatory dimension: 

1. Sub-Africa and South Asia = costly, complex and the legal institutions are not strong enough

2. Firm registration: New Zealand= 1 day and costs 0.4% of the local annual income per head. vs. Congo: 65 days, involves 10 steps and costs 551% of income per head.

3. Registering a property: Portugal= one day vs. Kiribati= 513 days

4. Obtaining a construction permit: Denmark=five steps vs. Russia=51 steps

5. Enforcing a contract via courts: Singapore=150 days vs. India=1420 days

6. Electricity connection: Liberia=586 days to connect vs. Ukraine=274 days vs. Germany=17! 

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Ease of doing business data (Country Rank 2011)

Top Ten:

Singapore, Hong Kong, New Zealand, USA, UK, Denmark, Norway, Ireland

Bottom Ten:

Haiti, Venezuala, Congo, Guinea, Chad

Policy Regimes:

- Choice is impacted by conditions and also the resources available. Dennis 2004 came up with policy regimes and looked at 2 dimensions: 

a) regulation difficulties (i.e. high impediments vs. low impediments where regulation=easy)

b) Assistance offered to small businessess (high direct vs. low direct)

Four groups: Competing (low impediments/low assistance=USA), Nurturing (high assistance/low impediments=UK, Canada), Limiting (high impediments/low assistance=developing countries), Compensating (high impediments/high assistance=EU countries)

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UK approach

UK Approach:

- Pre-1980's: little interest in small business

- 1980's focus on increase number of small businessess (Thatcher government)

- 1990's saw focus on increasing quality

- 2000's fixed portfolio approach

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Policies aimed at different people

- Policy aimed at entrepreneurship (new start ups) vs. small-business (assistance to grow)

-  Entrepreneurship for all (all new start ups) (everyone aware of benefits of the career. Lots of advantags but threats too i.e. Baumol 1990: businessess not providing a threat to existing businessess and most fail in first 2/3years or just make another go out of business!

-  Entrepreneurship for some (some new start ups) (certain groups in society: policitcal economy approach so that people do not feel discriminated or those in poorer areas of the country/unemployed. Sceptics think talent is not evenly distributed and cant say that everyone will the same support will be a success. Negative outcomes of encouraging someone to be entrepreneur when not ready=failure which may be very traumatic and have detrimental long term effects. 

-   Supporting all SMEs (all exisiting SME's and aim to grow them)

-   Support some SMEs (some exisiting SME's and aim to grow them)

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Groups of people policies 1

- Women: there are economic and social benefits for addressing the gender gap. Firm formation=women suffer discrimination in terms of remuneration, they need flexibility but cannot start a business/compete equally. Governments try to support women, number of businesses owned by women is 50% of that of men. Many more women entering entrepreneurism but there are still huge differences. Many programmes out there for women (CIPD etc.)! Government intervention could be justified in light of the political economy approach i.e. to gain votes. Government intervention justified in light of market failure: Women part of fewer networks+ may not have all the necessary info for starting a business hence why we may want to support women entrepreneurs. On the other hand, many societies are male dominated: examples of many male entrepreneurs, but not many women entrepreneurs. Issue with finance for women too. 

- Ethnic minorities: not homogenous group: not all EM's disadvantaged. Do not have necessary data to support the benefits of policies. Governments supporting ethnic minorities=minimal rigorous evidence to suggest that programmes made a difference+tax payers money contributed. Evidence of finance issues for blacks in USA. Ram&Jones 2008=unpersuaded by ethnic minority programmes. —Many Asian small business owners are stuck in highly competitive and precarious market niches (lower-order retailing); under capitalized; work long hours, intensively utilizing co-ethnic labour, struggling to survive in inner-city environments” (Blackburn & Ram, 2006).

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Groups of people policies 2

- Unemployed: Many advantages for intervening to support the unemployed i.e. saves welfare, reduces negative spillovers etc. Disadvantages: encourage unemployed to start up businesses but they often live in areas that are disadvantages i.e. North+these businesses may not be long lived as not demand+supply/demand wider issues. Little evidence to show that encouraging entrepreneurship will help people out of their situation=cannot solve all problems through entrepreneurship.—'Shorn of the fetters of government and meddling community groups, profit-seeking businesses will see money-making opportunities; they will capitalize on the competitive advantage of the inner-city and, in the process, employ lots of unemployed and underemployed local residents. The invisible hand, properly pointed to profit opportunities, can+will revive the languid economy of the inner-city” (Bates, 1997,Porter, 1995).—Even if private sector moves into deprived inner city= will not simply benefit poor residents,outsiders may be employed instead.

- The Enterprise Allowance Scheme (EAS) in 1980;s provided £40 a week for unemployed for 1 year if worked full time on the business, access to £1k capital and between 18-59, and business that was suitable for public support i.e. not a massage palour, Greene 2002 said advantages of this were brought previously informal activity into formal sector, cost less than JSA, may create more employment and individuals no longer counted as unemployed but survivial rates were lower than non-EAS businesses and after 1 year £40 subsidity ended, closure rates rose sharp. Businesses may have been set up even without the funding i.e. deadweight.

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Groups of people policies 3

Young people: rationale based on imperfect information, restricted access to finance, knowledge spillovers. Every developed country has particular programmes to support self-employment for young people. Evidence is very weak. Persistently high unemployment among young people is a common problem in UK. Potential solution=encouraging a ‘culture of enterprise’ among young people instead of a ‘culture of dependence’ by promoting self-employment as an alternative labour market option.— Research shows these programs tended to create not a culture of ‘enterprise’ but one of informal and risky work in low entry barrier, highly competitive sectors. Hard to survive such competition and even harder to grow a business (and create more jobs). —Most new businesses fail quickly, incur other forms of assistance to replace welfare dependency, end with debt and “fearful of further engagement in economic activity” (Blackburn & Ram, 2006).

- Evidence on particular groups: evidence is mixed: evaluation procedures are different.

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Groups of people policies 4

-   Supporting all SMEs (all exisiting SME's and aim to grow them all) - By supporting all SME’s we know advantages. Governments believe that SME’s are at a disadvantage to large firms that have power, market share, resources etc. To ensure a fair/level playing field for all enterprises, governments intervene. One policy that may impact all firms is: regulation! (tax etc.) This type of policy is problematic because SME’s are different. ‘One size fits all’ is difficult to design. Little intention from many SME’s to grow massively, just for the comfort of living. Advice and assistance= SOFT support. Focus on information to individuals because not all have the info to run a business. Offer advice and assistance. Advantages of this: all businesses have the same needs: government advice is often one size fits all and many argue this can be useless. 

Supporting some SMEs (some exisiting SME's and aim to grow some of them)- Interested in SME’s that are high growers/gazelles or support businesses that are sector specific i.e. high tech etc because they may have spill over on other similar businesses. Disadvantages of this type of policy of only supporting some SME’s: putting money into a business that is going to grow already! How can distinguish the growth from the individual’s objective or the advice/support offered? How can we find who the high growth businesses are? Business growth is very difficult to figure=temperamental. Who picks the winners? Actors? Public sector workers? Do they have the right skill to pick the right businesses to make the policy look successful? Governments are interested in being re-elected!!! Unethical element of choosing some SME's?

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The governments' tools to intervene:

1) Access and Provision of Finance: Loan guarantee schemes (LGS). BUT...lender cannot distinguish between good and bad lender – need collateral and/or ‘track record’ (information opacity). Absence of collateral alone prevents lending. LGS exist worldwide: government underwrites a portion of loan; charges a risk premium. Evidence suggests that LGS can play a positive role in supporting small businesses. The Enterprise Finance Guarantee (EFG) is a loan guarantee scheme to facilitate lending to viable businesses that have been turned down for a normal commercial loan due to a lack of security or a proven track record.

2) Grants: provided to correct equity imbalances and to support growth businesses. Some limited job creation evidence of impact. Distortive impact: businesses investments decided by grant. Destabilising impact: ‘grant hunters’. Likely to be high levels of deadweight/displacement. Princes Trust for young/unemployed: 23yr old Rebecca Taylor opened The Orginial Lash & Nail Bar in Doncaster (now has a turnover of £200k).  

3) Spreading/exporting support: Justified on the basis that exporting is a barrier to growth. Huge range of programmes worldwide. Evidence relies on self-report data but difficulties because of diversity of policy choices and limited take up. Overall, little persuasive evidence that advice and assistance enhance SME performance. EU SBA framework (advice)

4) Technology/Innovation: Justified because of importance of growth businesses being heavily concentrated in technology sector. Imperfect information also important: Technical entrepreneurs lack awareness and/or insights into running a business. Difficult to accurately gauge the economic value of a new product/service. Knowledge spillovers – small business are dynamic agents of change (diffusion)

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The governments' tools to intervene:

5) Business Incubators (Sussex innovation centre is one) 4 advantages: a) Shared office accommodation, b) shared support services (reduced overheads), c) advice and assistance & d) network provision. Disadvantages: often restricted to types of business (e.g. age or sector), difficult to assess worth: methodological challenges, value of incubator or incubator site? incubators can be prestigious but evidence of their value is mixed

6) R&D Funding: Justified because of growth and spillover effects. Many developed countries have such programmes (e.g. SBIR). Evidence tends to be supportive but questions about the evaluation methodologies of studies. Overall, innovation support looks on a cost-effective source of support. 

7) Policy Choices: Who delivers… public, private or quasi (e.g. not for profit)? Government civil servants (accountable). Private sector (favoured by SMEs). Mix of public/private (still tension between accountability and appropriateness) What ‘type’…generic, standard, tailored, regulated, face-to-face, e-based? How is it rationed…time, sector, price, market segmentation?Individual/business characteristics, time, price, mixed methods? How is it integrated…into other economic and social programmes? How is it funded…by charges, by donations, directly from public funds?

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