Rationale for intervention

4.2 At the outset of the appraisal process it is important to identify clearly why change is necessary. A statement of the rationale for intervention should be developed.

4.3 Understanding Business As Usual, or the status quo, provides the basis for an effective intervention. Business As Usual is the continuation of current arrangements as if the intervention under consideration were not to be implemented. This does not mean doing nothing, although it is often referred to as the Do Nothing option, but continuing without making any changes. It is necessary to work out what the consequences of inaction would be (even if unlikely to be acceptable), as it provides the relevant counterfactual to compare alternative options.

4.4 The rationale for intervention can be based on strategic objectives, improvements to existing policy, market failure or distributional objectives that the government wishes to meet.

4.5 Market failure is where the market mechanism alone cannot achieve economic efficiency. Economic efficiency is achieved when nobody can be made better off without someone else being made worse off. Economic efficiency enhances social welfare by ensuring resources are allocated and used in the most productive manner possible. One potential cause of inefficiency is when the private returns to an individual or firm from carrying out a particular action or activity differs from the returns to society as a whole, meaning there are external costs or benefits. Box 4 provides examples of possible market failure.

4.6 To provide a useful rationale which will support development of the intervention it is necessary to identify the specific market failure being addressed, rather than describing this in general terms.

4.7 Polices also need to be assessed to ensure that government actions and interventions in themselves do not lead to perverse incentives or create moral hazard. It is important to understand the effects of actions and interventions on individuals, businesses and markets. This is particularly important when assessing any form of PPP or strategic partnering arrangements with the private sector. It is critical to understand what risks are being transferred between public and private participants, that contracts are designed to ensure private sector partners are able to manage those risks and that they are held accountable for doing so.

Box 4. Market Failure

Market failure is when the market mechanism alone cannot achieve economic efficiency. Examples of the causes of market failure include:

  Public goods: Many aspects of the environment, for example the benefits of clean air, can be described as public goods. We can all enjoy clean air. It is difficult to actively exclude anyone from enjoying it (non-excludable in supply) and once provided, it largely doesn't matter how many people enjoy it (non-rival in demand). These features mean it is difficult for businesses to provide public goods and they are often provided (or in the case of the environment, protected) by government policies. A public good will be both non-rival and non-excludable.

  Imperfect information: Information is needed for markets to operate efficiently. Buyers need to know the quality of a good or service to judge the value it can provide. Sellers, lenders and investors need to know the reliability of a buyer, borrower or entrepreneur. This information must be available to all or there is 'asymmetry of information' which could lead to moral hazard or adverse selection. This affects markets such as life insurance, as companies may not be able to verify information (e.g. whether an individual is a smoker) and may not be willing to sell insurance to everyone willing to buy it.

  Moral hazard occurs when individuals or businesses change their behaviour and takes risks because they are protected from negative consequences e.g. someone else bears the costs.

  Externalities: These occur when an activity produces benefits or costs for others. Negative externalities are associated with, for example, passive or second-hand smoking. An individual may smoke tobacco indoors, in the presence of others, who inhale the tobacco smoke and damage their health. The smoker imposes an external cost on others, which would not be accounted for in the price of cigarettes without government intervention.

  Market power: This results from insufficient actual or potential competition to ensure that a market operates efficiently. High start-up costs can deter entry by competitors and create market power. This situation may be exacerbated by organisations acting strategically to protect their market position. For example, when an organisation engages in a practice known as 'predatory pricing', where prices are set low to drive out competitors and then raised once they have left.

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