To provide companies with financial inducements implies once again that the market has in some sense ‘failed’. However, in order to understand why the ‘carrot’ rather than the ‘stick’ approach to preventing market failure is perceived as necessary by governments, we need to look beyond the economist's definition of such failure as inefficient allocation of resources (see Module 3). In general, the ‘carrot’ approach is associated with the aim of ensuring that the economy adapts satisfactorily to changes in domestic and international demand and to changes in technology, and in a way which ensures that employment levels remain high and standards of living (and therefore the rate of economic growth) rise at an ‘acceptable’ pace. It therefore rests on a view of the working of the economy which maintains that achieving efficient allocation of resources, e.g. by removing barriers to competition, is not sufficient to ensure that these long-term aims are met. According to this view, entrepreneurs require stimuli other than market signals in order to adapt quickly enough to changes in their product and factor markets, if their actions are to conform to policy aims. Furthermore, as we shall see, financial inducements are frequently specific to particular industries and there may be no automatic entitlement to their receipt. This implies that general fiscal measures such as alterations in the rate of corporation tax or income tax, which automatically affect a wide range of companies and persons, are not considered sufficiently geared to achieving the long-term aims of output and employment growth. Financial inducements are therefore frequently selective in character and are designed to affect the composition as well as the level of national output.
The global aims mentioned in Section 6.2.1 are reflected in so-called ‘structural’ policies, of which three are identified in this module.
In the individual company, the pace of adjustment to changes in demand and supply conditions will be determined by the effect of these changes on its profitability. In the extreme case, companies may close down temporarily or permanently in response to profit incentives. When closures threaten an entire industry or are concentrated in a particular region, and the economic costs to labour of seeking and obtaining alternative employment are high, governments will often try to ‘plan’ the contraction of firms. In order to reduce the costs of adjustment to the factors of production affected by contraction, subsidies to output or employment may be used, if for no other reason than to avoid loss of political support for the government in power.
A famous historical example is the Central Wales railway line. Despite the fact that it was estimated that it would be cheaper to hire taxis to convey the few users of the line to their destinations than to keep the line open, the UK Labour Government (1964–70) ignored the advice of the then Ministry of Transport and subsidised the British Railways Board to keep the line open. Apart from being an expensive method of maintaining employment, it is claimed that the main reason for not closing the line was because it ran through six marginal constituencies.
This aim is closely tied up with the first. The terms of sale of goods of companies which trade internationally are vitally affected by exchange rates and by intervention by overseas governments designed to discriminate against imports and encourage their own exports. Companies therefore seek to lobby their own governments in order to favour their products either by some form of subsidy to exports or by promoting import substitution. Governments have then to consider which is the most appropriate instrument to use to promote this policy. One method is to use financial inducements; others include tariff protection and exchange rate policies.
EC countries have used a variety of methods for promoting their exports. These have included subsidised insurance against default by overseas buyers of exports, finance of trade fairs and trade missions, and export market research. The commitment to a single European market must require government to charge for such services. See also Example 6.12.
Companies will invest in new products and new processes only to the extent that they improve profitability. It is claimed that, left to themselves, companies under-invest in new products and processes, for they have no incentive to gear their investment to take account of any spin-offs resulting from the exploitation of new techniques. Furthermore, companies have to face the fact that launching new products and processes may embody high risk which may lead them to restrict their R and D activities to safe projects. Some pooling of risks may increase the flow of innovations and reduce the costs of exploiting such innovations. Under-investment may be prevented by government subsidies to investment designed to promote spin-off effects and to reduce the long-run costs of innovation. The benefits of financial inducements, therefore, may be measured in terms of the expected increase in economic growth and in employment opportunities.
A considerable proportion of R and D expenditure undertaken by firms is financed by government, as shown in Table 6.2. Government finance tends to be concentrated in R and D intensive sectors notably Defence, aerospace, pharmaceuticals, and scientific research and training in universities and specialised institutes
| UK | France | Germany | Japan | USA | |
| % GDP of total R&D | 1.94 | 2.31 | 2.28 | 2.77 | 2.52 |
| % Government financed | 31.8 | 42.3 | 37.3 | 20.9 | 34.6 |
| % Govt-finance in selected sectors: | |||||
| Industrial development | 2.5 | 4.8 | 13.3 | 3.4 | 0.6 |
| Health | 14.5 | 5.2 | 3.3 | 3.5 | 17.6 |
| Advancement of knowledge | 29.7 | 35.2 | 52.2 | 48.6 | 4.1 |
| Defence | 37.2 | 28.9 | 9.8 | 5.8 | 54.7 |
Source: based on Tables 7a and 7b in Stoneman (1999)
What has been stated so far is the rationale of policies which require the use of financial inducements to influence how companies behave. It will be shown in later analysis (see Section 6.4) that determination of government policy aims is a complex process, that the economic reasoning behind the link between these inducements and what they are designed to achieve may be tenuous, and that considerable controversy surrounds the assessment of the relative efficiency of using financial inducements as compared with other policy instruments.
