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Market failure justification government intervention in sme sector

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Regardless of their definition, Small and Medium sized enterprises account for a large percentage of businesses worldwide, and are key contributors to a country’s economy. SMEs are the engine in the economy – the driving force behind job creation – and are characterised by innovation, rapid expansion, and adaptability (Zimmerer et al, 2008). Termed “ entrepreneurial growth companies” or “ gazelles”, they represent over 90 % of businesses and generate net employment of over £4 million (Storey, 2006). Despite their role in economic development, however, SME’s suffer high mortality rates and face significant obstacles in both the start-up phase of business and short term business operations (Berger & Udell, 2006). In the midst of both national and international competition, gazelles must overcome inefficient capital markets, lack of resources, lack of transparency, constant instability, and shortages of credit availability in order to succeed (Kim et al., 2008). Hence, it is argued that, only with government intervention, can SMEs avoid hurtling down the precipice that is business failure.

Small and Medium Sized Enterprises: A Brief Overview

SMEs : A Definition

Small and Medium Enterprises are of pivotal importance in the economy, and yet, a consensus regarding their definition is yet to be reached (Storey, 2006). Nevertheless, a widely accepted definition classifies SMEs as firms that (1) have a relatively small market share, (2) are not managed solely through a formalised management structure and (3) are independent of larger enterprises. Despite wide recognition of the Bolton Committee´s (1971) definition of SMEs, limitations of its applicability in reality have lead to the formation of alternative definitions, such as that introduced by Wynarczyk (cited by Storey, 2006). Originating from the work of Penrose, he argues that other than a deviation in size, it is uncertainty, innovation and evolution, which allow for the differentiation between SMEs and Large Enterprises. Hence, the fundamental characteristics of SMEs include resource poverty, heightened uncertainty, their role in innovatory processes and their adaptability (i. e. likelihood of evolution) (Welsh & White, 1981). This notion is further supported by MacCartan-Quinn & Carson (2003), whom argue that SMEs have a competitive edge over larger firms in regards to the latter, but are limited by a lack of market power, undercapitalisation and an inefficient management structure. Consequently, SMEs find survival in an ocean saturated with large predators a difficult task.

The SME Sector in the United Kingdom and its importance in the economy

“ Small firms play a crucial role in our economy. [They] do not follow the economy – they lead it”

UK chancellor of the Exchequer, 1993

With the inherent difficulties associated with defining the sector as a whole, it is not surprising that there is no conclusive information regarding the size of the SME sector in the UK (Everett & Watson, 1998). Nevertheless, MacCartan-Quinn and Carson (2003). highlighted that, under the European Comission definition of an SME , ≤ 10 employees, the sector constitutes 92 % of all UK businesses (table 1). With an estimated 4. 3 million SMEs in the UK, they account for 55 % of national employment and 51 % of annual turnover (DTI, 2006 andJones & Tilley, 2003). As underlined previously, the importance of SMEs in a country’s economy is largely related to the job creation process and hence, the reduction of unemployment (Torre et al., 2010). As eloquently stated by Storey, “ today, any consideration of the small firm sector which overlooks [the contribution of SMEs to employment] would be like Hamlet without the prince” (2006). Unlike large firms, whose contributions to employment statistics fluctuate depending on the economic climate, small and medium sized enterprises are consistent in the provision of employment opportunities, irrespective of macroeconomic conditions (Kim et al., 2008). The suggestion that SME´s role in employment creation does not vary with changes in the trade cycle is further supported by Schuman (1985, cited by Bartlett, 2001). He argues that UK businesses with ≤ 20 employees made the largest contribution to net job change ( + 20 %), with values varying very little between the different time periods. Furthermore, the SME sector is an essential for (1) innovation, (2) development of a highly competitive environment (3) technological progress (4) revival of certain regions (5) the production of intermediate goods through subcontract arrangements with larger firms and (6) economic growth (Bartlett, 2001).

Turbulent Waters: Market Failure and the SME

Market Failure: A Reason for Concern

According to Allocation theory, market failure refers to the failure of price-market institutions in sustaining activities deemed desirable in the economy. It is essentially a situation in which resources are not allocated to their highest valued use or maximum welfare potential (Bator, 1958). Hence, at equilibrium, competitive markets will coincide with the conditions as dictated by Pareto Optimality – i. e. optimal utility efficiency. However, with imperfect information, financial gaps, compliance costs, resistance to change and uncertainty, very rarely does such a situation occur.

Despite their importance in the economy, SMEs, in the midst of a highly competitive environment, struggle to survive (Cressy, 2006). As a result of limited resources, both financial and human, economic instability, minimal economies of scale, unevenness of fixed costs and a constant influx of competition, the risk of failure in SMEs is high (Kim et al., 2008). With mortality rates exceeding 50 % after only 3 years in business, SMEs must overcome significant obstacles in order to develop, gain competitive advantage and function effectively on both a national and international scale (refer to figure 1); ” Not only does the business have to run to stand still, it also has a long way to run” (Atkinson & Storey, 1994, p. 100).

SMEs: Barriers to Growth

According to Bartlett, financial barriers are one of the most significant impediments to SME growth and development (2001). Though the value of the finance gap has fallen since its publication, SMEs still struggle to obtain sufficient levels of long term equity capital to finance business start -up and operations (Storey, 2006). As a result, “ the next Google, Microsoft or Starbucks might wither on the vine for want of funding” (Craig et al., 2008, p. 346). With institutional problems including asymmetric information, agency issues, higher objective risk, and costly monitoring, the availability of financial assistance from banks is limited (Berger & Udell, 2006). Although initiatives to increase access to financing, such as government subsidized credit lines, are in existence, the “ opaque” nature of the sector acts as a financial constraint (Torre et al., 2010). Given that SMEs have limited resources, financial institution’s interest rates are high, equity capital is only given against collateral, willingness is curbed by the high risk nature of the sector, and foreclosure, in the midst of difficulties, is rapid (Cressy, 2006). Hence, take-up of such funding in the UK is often less than 10 % (Curran, 2000). However, as argued by Torre, providing capital is only one string in the web of offerings such financial institutions have available to SMEs (2010). With cross- selling at the core of their policies, banks provide a variety of fee -based services including financial advisement, technical expertise and private consulting (Bennet, 2008). Reiterated by Vos et al., the network of ties created by such services will develop a firm’s competitive advantage through the generation of “ knowledge spillover effects” (2007). Additionally, while the scale of the UK venture capital industry has increased exponentially, provision of capital in the early stages of SME development accounts for only 1/5 of the total investment seen in the past 10 years (Cressy, 2006). As SMEs, from an investment perspective, are riskier in regards to their propensity to fail, funds provided by venture capitalism in the UK are geared more towards management buy -outs and buy-ins (Vos et al., 2007).

Policy: A Potential Solution

Public Policy and SMEs

With unanimous consensus in business literature, the lack of availability of equity capital for SMEs is highly attributed to the existence of a “ gap” – also termed market failure or credit rationing (Storey, 2006). Defined as an unwillingness of equity suppliers to provide financial assistance on the terms and conditions required by SMEs, it highlights the difficulty in the acquisition of bank finance and external equity participation (Berger & Udell, 2006). In practice, public policy geared towards SMEs is concerned with both the creation of employment opportunities and improving SME access to external financing. Although the broad objectives are consistent among policies, the functionality of the policies themselves differ according to the underlying causes of market failure. While policies targeting endogenous or internal market failure focus on developmental strategies and the organisational “ backbone”, those directed at the exogenous causes aim to change the economic environment to which the firm is bound (Everett & Watson, 1998). Though there are numerous public support schemes in existence, European governments are yet to develop a coherent scheme towards the SME sector (Everett & Watson, 1998). According to Storey “ public policies have been developed, jettisoned, and often reintroduced on a piecemeal basis”(2006, p. 253).

Justifications for Government Policy

Economists claim that justifying government intervention in the economy is only warranted in the event of market failure, which in the SME sector, refers to the failure of financial markets in providing equity to apparently viable small firms (Hughes, 1997). Liberal economics, however, argues that while the existence of market failure may have empirical validity, it is not a sufficient argument for the pursuit of such initiatives. Even in today’s economy, following the development of numerous initiatives, it appears a contradiction that a government whose framework relies on the concept of free markets can pursue policies geared at promoting one sector. Of even more interest is the fact that little justification is provided by the UK government with market failure as the core argument (Curran, 2000). Nevertheless, the economic rationales for such policies are often based on the argument that increasing SME resources will enhance competitive advantage, economic performance and firm survival, which in turn will influence the country’s employment rates (i. e. provides a positive externality)(Craig et al., 2008).

As highlighted previously, the most widely recognized argument for the development and implementation of SME focused government policy relates to their role in the generation of employment opportunities. While the existence of SMEs may yield efficiency gains in the economy, however, they are not an “ independent” motor for employment growth and thus, their importance in job creation is not necessarily a justification for the refocus of public policy (Storey, 2006). The second argument, which is often considered more sophisticated than the latter, is that a specific form of market failure is linked to SMEs as a result of their high unit cost of compliance to regulations and their lack of competitive advantage in the marketplace. The limited internal resources associated with SMEs are seen as a key justification for public policy aimed at levelling the playing field. (North et al, 2001). Hence, SMEs warrant government support to compensate for the disadvantages inherent in the sector, not to provide them with an unfavourable advantage. For instance, the cost of compliance associated with VAT for SMEs constitutes 2. 5 % of annual turnover – a value that is approximately 35 times greater than the cost incurred by larger firms.

Furthermore, some literature argues that the survival of SMEs is key to the maintenance of a competitive market place. The constant influx of competition not only prevents larger firms from abusing monopoly power, but inhibits the generation of excessive profit margins through high fixed prices. Though these arguments are valid to a large extent, quantifying the differences in cost with numerical values is difficult (Curran, 2000). For example, larger firms often have lower production costs per unit as they can purchase materials in greater numbers. While such an example of economies of scale is considered to occur “ naturally”, legislative compliance costs, which function in a similar manner, are not classified as such. As a result, policies may seek to exempt SMEs from certain areas of legislations on the basis of high compliance costs without recognising the possible ramifications on the economy as a whole (Storey, 2006). Consequently, justification of such measures requires both the precise identification of market failure and evaluation of the feasibility of intervention as a means to rectify it.

SME Government Policies in the United Kingdom

Though an established conceptual framework of Small Firm Government Policy is not available, Curran (2000) underlined that increased competition, strengthening of the production chain, diversification, promotion of an enterprise culture and creation of employment were key objectives pursued by European countries, UK inclusive. In the 1990´s alone, more than 100 initiatives targeting SMEs were introduced by the UK government (Jones & Tilley, 2003). It is not surprising, however, that a comprehensive overview of the policies currently in place is not in existence. Echoed by various authors, public policy targeting SMEs in the UK is a “ patchwork quilt of complexity and idiosyncrasy” (Curran, 2000, p. 36 ). Nevertheless, Storey (2006) suggests that, based on the work of Bannock and Binks (1990) and Barberis and May (1993), SME focused public policies can be subcategorised into 5 areas (refer to table 2):


Sectoral and Problem – specific

Interest Rates

High tech firms


Rural Businesses

Public Spending

Community enterprises


Co – operatives


Indirect Assistance

Removal of Red Tape


Legislative Exemptions

Access to information

Legal Form

Training and advisement

Financial Assistance

Business Expansion Scheme

Loan Guarantee Scheme

Macroeconomic Policies

Macroeconomic policies are of pivotal importance as not only do they affect the trading position of SMEs, but they target the economy in its entirety, providing a stage in which all firms may flourish. Encompassing factors such as interest rates, taxation, public spending and inflation, such policies are key determinants of aggregate demand, total revenue and hence, SME performance (Everett & Watson, 1998). With government initiatives focusing predominantly on the manipulation of taxation regimes, schemes encompass reductions in income and corporation tax, abolishment of investment income surcharges and the provision of reliefs. With 30 – 50 % of business failure in the sector attributed to exogenous variables, government schemes targeting the macro economy, undoubtedly, influence the viability of SMEs (Everett & Watson, 1998). However, several critics claim that focus should be placed on altering aggregate demand and Interest rates as opposed to taxation, which incurs a high risk of having its original objectives distorted (Storey, 2006).


Deregulation and administration simplification policies aim to minimize the “ red tape” associated with business start-up and operational activities (Berger & Udell, 2006). A mechanism of limiting the administrative and bureaucratic barriers that SMEs must face, deregulation involves freeing markets, allowing for an influx of competition, removing legislative burdens and ultimately, refocusing resources to business operations. In the UK, such policies have involved alterations in the VAT system and a simplification in business registration procedures (Storey, 2006). Evaluation of the effectiveness of such policies is problematic and, as highlighted by various critics, a conflict of interest if often seen between SME’s perception of administrative barriers and legitimate rights in terms of both employment and the environment (North et al., 2001).

Policies specific to the sector

In contrast to other public schemes, sectoral initiatives target a specific group of SMEs. Based on geographical differences, sector specifications etc, such policies address problems unique to high-tech firms, rural businesses, community firms, co -ops and ethnic enterprises. In such situations, government intervention is deemed necessary as market failure exists as a result appropriability, accessibility, and disadvantages inherent in the business’s foundational framework. These government policies, such as “ The Smart Scheme”, are centred on improving the availability of government/ external funding, promoting the enterprises and developing their facilities / corporate governance structure (Berger & Udell, 2006). The justification and effectiveness of such policies in the UK, however, remains open to question (North et al., 2001).

Financial and Indirect Assistance

Despite the lack of financing available in the private sector for SMEs, recent years has seen significant growth in the number of public sector initiatives aimed at increasing the availability of capital (Hinloopen, 2004). In retrospect, however, the success of financial intervention through public sector schemes (Loan guarantee & Enterprise Investment) is limited. The use of the taxation system to support SMEs in the acquisition of financial assistance have either been counterproductive or used as tax avoidance mechanisms (Storey, 2006). As a result, current policies rather focus on (1) the provision of grants through the Enterprise Allowance Scheme and (2) the provision of indirect assistance to compensate for imperfections in the marketplace (Bergstrom, 2000). Encompassing policies such as “ the Business Link”, these schemes are aimed at improving the availability of information, training and professional advice (Bennett, 2008). Hence, indirect assistance addresses market failure by improving the core of business operations. By improving internal communication, knowledge, management quality, and access to external expertise through subsidies, such initiatives essentially help businesses help themselves (Everett and Watson, 1998). The success of indirect assistance in improving firm efficiency and hence, counterbalancing market failure in SMEs, is well documented (Bergstrom, 2000 and Hinloopen, 2004).

SME Market Failure: A justification for Government Intervention?

As highlighted previously, research suggests that, from an economic perspective, there is a justification for certain government policies targeting Small and Medium Sized Enterprises (Storey, 2006). As SMEs fulfil an important economic role, and will continue to do so in the future, the government should provide assistance, as without it, a large percentage of SMEs will drown in the abyss that is the business environment. Given the importance of both internal and external factors in the existence of “ market failure “, such policies must target not only the firm as an individual entity, but the macro economy as a whole (Hughes, 1997). Such initiatives may encompass development of the corporate governance structure, provision of developmental opportunities, improving access to external expertise, encouraging investment by business angels, manipulating interest rates, taxation, and public spending (Hughes, 1997 and North et al., 2001). While existing schemes concerned with start -ups, training, wider access to professional advice, and minimising administrative barriers are largely successful in closing the market gap (i. e. addressing market failure), a need to address policy limitations and further develop macroeconomic initiatives, exists. There is wide agreement that a greater degree of “ holism” is required in the development, implementation and integration of UK public policies (North et al., 2001). Hence, the government needs to exploit their role as a catalyst and regulator by developing policies that (Han & Benson, 2010):

Table 3 : Public Policies in the UK that warrant development (Adapted from Bennet, 2008)

Improve the provision of equity funding

Stimulate investment in firms by business angels

Promote “ plough back” of SMEs via tax reductions

Encourage sharing of the risk of ownership

Reduce the burdens and costs for SMEs

Capitalise on firm information and solve asymmetry


While there is little consensus regarding the definition of SMEs, unanimous agreement regarding the difficulties inherent in the sector exists. Despite their importance in innovation, employment and economic development, SMEs suffer high mortality rates due to weaknesses within firm governance, capitalisation and credit availability (Bennet, 2008). SMEs are hence, perceived as “ valuable yet vulnerable entities” in need of government assistance (MacCartan-Quinn & Carson, 2003). Despite the handicaps associated with government initiatives in the UK, it is evident that, in the midst of a maze of institutional, financial and developmental barriers, public policies pave the road to firm survival.

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