Privatization: Is it the Answer?

AUGUST 01, 1983 by E.C. PASOUR

Dr. Pasour is Professor of Economics at North Carolina State University at Raleigh. Some of the material in this article was adapted from his “Government Provision and Production of Goods and Services,” Tar Heel Economist, North Carolina State University, Raleigh, April 1983.

During the past 50 years, there has been a pronounced shift in economic activity from the private to the public sector as government expenditures (local, state, and federal) in creased from an eighth to a third of Gross National Product. In recent years, mounting budget deficits and dissatisfaction with both the quality and cost of governmentally provided goods and services—including education, law enforcement, roads, mail service, health care, public utilities, and welfare programs—have heightened interest in the appropriate role of government at all levels. This growing interest in the appropriate role of government coincides with the “privatization” movement.

Privatization involves the extension of market principles to goods and services currently financed and/or produced by government. Relying on mounting empirical evidence, it suggests that many activities currently performed by government could better be done by private firms. This paper explores the advantages of privatization and the limits of halfway privatization measures which are not rooted in private property and private control.

In his recent book, Privatizing the Public Sector, E. S. Savas cites evidence that private companies relative to government agencies can provide fire protection, mail service, garbage collection, health care and a host of other services at lower cost.[1] Savas discusses a number of ways to halt and reverse the role of government. Four of the most important ways of increasing the role of market forces in the delivery of goods and services are contracting out, franchises, user fees, and “load shedding.”

Market Processes

In contracting out such activities as refuse collection and fire protection services, government remains responsible for financing but selects one or more providers through competitive bidding. In contrast, an exclusive franchise is an award of monopoly privilege to a private firm to provide a particular service usually with price regulation by an agency of government. Electric power, gas and water distribution, telephone service and cable TV are often provided as franchise services. Whereas government pays the producer for services contracted out, the consumer pays the producer for franchise services.

In the case of user fees, users bear some or all of the cost of the good or service provided by government. During the past five years, for example, a number of cities have instituted specific fees to pay exclusively for garbage service.[2] The use of user charges is technically feasible wherever nonpayers can be excluded from the use of a good or service.[3]

Finally, “load-shedding” is complete privatization where government bows out and allows the private sector to produce the service and offer it directly to consumers. An example is municipal refuse collection where towns and cities get completely out of the garbage collection business and allow free competition. A recent proposal to have the federal government sell some of the publicly owned timber and grazing lands is another timely example of “load shedding.”[4]

What are the advantages of privatization? Most people value the freedom to choose, and competition among suppliers of goods and services is important in maintaining consumer choice. It is ironic that while private sector monopolies in the United States are legally pro hibited by antitrust laws, it is often assumed that firms competing with the Post Office and other public sec-tot agencies constitute wasteful duplication. It is the thesis of this paper that increased market competition is important in improving mail service and many other activi ties currently financed and produced by government.

Expanding choice and diversity of consumer goods and services thus involves a strategy of increasing competition in activities where government is now dominant including mail services, education, Social Security, and other areas where competition, if not prohibited, is at least inhibited. In so far as it serves to increase competition, privatization has the potential to reduce the stultifying effects of government provision and production of goods and services. Consider some of the problems inherent in government financing and production of goods and services.

Pricing Problems in Education and Other Government Projects

Private and secondary education is the largest function of state and local government in the United States as measured by size of budget or number of employees. Although state-run schools do not have a legal monopoly, parents of children in privately financed schools must pay twice for education—once through taxes to support state-run schools and again through tuition payments to the schools of their choice. Consequently, financial considerations induce many students to attend state-run schools. A range of proposals, including tax deductions for tuition expenses and compensatory tuition vouchers to low-income families, are increasingly being discussed as ways to increase competition and expand parental choice. Regardless of the merits of these particular proposals, they illustrate the fact that government provision of education (educational financing) does not imply government production of educational services (government-run schools). A failure to maintain the distinction between government financing and government production has undoubtedly contributed to the current strongly centralized educational system.

At least some of the increase in government production of goods and services is due to pricing methods used. When the price of a good or service is reduced below the market- clearing level, consumers are not able to obtain as much as they desire at the going price. Although shortages of government services including water, parks, other recreational fa cilities, and so on, are often taken as evidence that government is spending too little on these activities, shortages merely reflect prices arbitrarily set too low on the basis of current supply and demand conditions. That is, a shortage is created whenever price is arbitrarily held below the market-clearing level.

Government goods and services are priced below cost to users for at least two reasons. First, local and state expenditures for public transportation, health care, environmental protection, and other services have been increased because of revenue-sharing arrangements involving matching federal funds. In these cases, the cost borne by taxpayers at the local or state level to provide the service is not the full cost of the service. If an owner of a grocery store were to price milk or bread at half the normal price, customers would buy considerably more milk than when the price reflects the full cost. Similarly, the demand for governmental services at the local or state level is increased by “revenue-sharing” arrangements where citizens, ostensibly at least, can obtain a larger amount of goods and services for a given outlay.

Of course the “shared revenue” involves a cost, but it is largely borne by other taxpayers. Communities which forgo revenue sharing and finance services on their own must pay twice—once through taxes to support revenue sharing and again through local taxes to provide the service in question. Consequently as long as the revenue-sharing system exists, every qualifying unit of government has a financial incentive to “get its share.”

Second, even when financing occurs fully at the state, local, or federal level, publicly provided goods and services such as water, garbage collection, libraries, parks, golf courses, and so on, are often under-priced due to political considerations or equity reasons. There is a strong feeling on the part of many people that water, education, and other “necessities” should be provided below cost to assure that the service is provided to lower-income groups. In addition, since the quantity demanded of a product is greater the lower the price, there are advantages both to political incumbents and to government employees in pricing goods and services below cost. Thus, water, museums, recreational facilities, governmental publications, and other collectively provided goods and services are frequently underpriced regardless of the income level of the recipient. Users are then induced to demand “too much” of these goods and services.

The preceding discussion implies an expanded role in the use of user charges, where nonpayers can readily be excluded, for a wide variety of government activities including such services as roads, bridges, airport landing rights, elementary, secondary, and higher education, water, refuse collection, museums, public parks and many other recreational facilities.

How about roads? Toll roads and streets are technically feasible but involve high transactions costs. However, technological improvements in electronic sensing devices permitting autos to be charged for the use of particular roads could greatly reduce the high transactions costs associated with toll roads and streets. Automated vehicle identification systems which would allow vehicles so equipped to bypass toll booths and be billed monthly are nearing commercial feasibility.[5]

There are also opportunities, as Savas suggests, to have private firms produce many of the services traditionally provided by government, including fire protection, mail service, health care, and garbage collection. In the case of garbage collection, for example, contracting out of residential collection has shown impressive savings: “Nationwide studies in the United States, Canada, and Switzerland, as well as regional studies in Connecticut and the Midwest, have shown that government garbage collection is 29 to 37 percent more costly than private contract collection.”[6] Thus, even if “load shedding” is not achieved, improvements can be made in the production and pricing of many government services.

Limits of Increased Efficiency

As shown below, however, it isn’t possible to achieve the full advantages of “load shedding”—of private provision and production in decentralized markets—through the use of user charges, contracting out, franchise, and other half-way privatization measures. That is, there are limits in the extent to which the advantages of decentralized markets can be achieved in government provision and production, or in government monitoring of goods and services produced under contracting out and franchise arrangements.

Attempts to apply market methods to the provision and production of goods and services produced under the aegis of the state must overcome inherent information and incentive problems. Consider first the information problems confronting taxpayers and other citizens in monitoring prices charged for goods and services produced by government. Even if the price of water, garbage collection (or other service) is set high enough to prevent a shortage, there is no objective basis in the absence of competition for determining whether the price charged is too high. That is, the individual user in the absence of alternatives has no objective way to evaluate prices of government services such as garbage collection and fire protection.

The information problem is no less tractable in the case of government monitoring of prices of electricity and other utilities produced under government franchise. Any monitoring agency, presumably in attempting to set price on the basis of cost, only has access to firm accounting costs. These past outlays, however, have no relevance to today’s decisions. It is the expected costs and returns based on future economic conditions which influence current entrepreneurial decisions. And, since the future is always uncertain, there is no reason to expect the outside observer in the monitoring agency to make the same assessment of these conditions as the decision-maker in the regulated firm.

The incentive problems associated with government financing and production of goods and services are no less formidable than the information problems just discussed. In competitive markets, decisions are made on the basis of expected profits or losses, and the conduct of the entrepreneur is constrained by profit considerations. In order to reap financial rewards, the private entrepreneur must successfully anticipate consumer wishes and satisfy them at a competitive price. The market process provides an incentive for good performance and a mechanism to reallocate resources to those best able to use them. Thus, the businessman is induced by profit reasons to hire competent labor, to economize in purchasing inputs, to price products competitively, and to maintain product quality. In the words of Ludwig von Mises:

Because this is so, there is no danger in leaving important decisions to his discretion. He will not waste money in the purchase of products and services. He will not hire incompetent assistants and workers; he will not discharge able collaborators in order to replace them by incompetent personal friends or relatives. His conduct is subject to the incorruptible judgment of an unbribable tribunal: the account of profit and loss.[7]

The situation is likely to be quite different under government financing, production, or monitoring. Government agencies are generally not profit-seeking enterprises, and profit and loss considerations have relatively little effect on production and marketing decisions. That is, bureaucrats and politicians do not face incentives that foster good performance. The results of central planning whether for land, garbage collection, production of electric power, or for the entire economy are clear. Resources publicly owned or controlled cannot efficiently accommodate consumer wishes when contrasted with private ownership and control.

Even if information problems could be overcome, incentive problems would prevent the efficient use of resources allocated through central direction.[8] In contracting out or franchise arrangements, for example, opportunities for financial gain by decision-makers in government agencies are created by the method of selecting the firm to provide the service. Thus if government selects only one supplier for a service—whether it is for bus transportation, refuse collection, cable TV or some other service—the potential windfall gains to the firm obtaining the franchise provide an incentive for firms to engage in bribery and other “rent-seeking” activity and for public officials to respond.

Furthermore, firms operating under profit controls have an incentive to use the controls to their own advantage. In the case of a firm operating under government franchise where price charged is to be based on production cost, for example, management has an incentive to inflate costs by padding expense accounts, by taking expensive business trips, and by taking returns in the form of such nonmonetary perquisites as lavishly decorated offices including thick carpeting, expensive furniture, expensive paintings, and so on.

Similar information and incentive problems are also endemic in the “scientific” approach to management of public land. The aim of the early conservation movement in the United States was to introduce “scientific management” into government.[9] If government is to function efficiently, according to this view, politics must be confined to specifying general policy directions, leaving the actual administration to skilled professionals. In view of the information and incentive problems inherent both in government production and in governmental monitoring of private production, widespread dissatisfaction with the results of “scientific management” of rangelands, forests and other publicly owned lands is not surprising.

Conclusions and Implications

Savas, after analyzing a number of studies comparing public and private provision of services, concludes that “. . . those who believe on a priori grounds that private services are best can find considerable support for their position.”[10] Information and incentive problems are endemic in all non-market production and financing arrangements. First, as described above, there is a separation of power and knowledge—creating information problems. Those in power do not have and cannot obtain the information which is automatically conveyed between producers and consumers through market prices.

Second, in the provision and production of goods and services through government, there is a separation of power and responsibility creating incentive problems. Politicians and bureaucrats are typically motivated by short-run considerations such as the next election and are never solely responsible for their actions. Ramsey, in making a case for the privatization of the New York City subway system, emphasizes the incentive problems inherent in public ownership:

Private management is far more efficient than public management, simply because of the difference in the pressures it faces. In publicly owned firms not only are there fewer and smaller personal incentives to be efficient but the politically expedient response, which tends to solve today’s difficulty at tomorrow’s expense, is ever present. This is because the time horizon for the payoff from political decisions is very short, often less than a year and seldom greater than a couple of years. Better for the politician to curry favor now and leave the problems to the next administration, the next generation of users.[11]

It is not possible to obtain the advantages of competitive markets in government provision or production of goods and services. While shifting productive activities from the federal to state or local governments along with the adoption of user fees, contracting out, franchises, and other quasi-market arrangements may improve collectively provided or produced goods and services, these arrangements do not and cannot provide the incentive and informational advantages of load shedding—that is, of decentralized competitive markets.

Competitive markets are rooted in private property, and there is no way to simulate competitive conditions under conditions of government financing or government production. F. A. Hayek and Ludwig von Mises, in the economic calculation debate, demonstrated that the concept of markets without property is a “grand illusion” and that economic calculation is impossible unless markets are organized on the basis of private ownership of property. Thus, while the efficiency of government activity may be increased by the imposition of user charges, by maintaining flexible prices to eliminate shortages and surpluses, by contracting out and franchise arrangements, or by other half-way privatization measures, there is no reliable benchmark against which to compare governmentally produced goods and services in the absence of private property.

In short, regardless of whether the economic problem concerns land use, garbage collection, electricity, milk, or another good or service, there is no other way to achieve the benefits of decentralized competitive markets. Privatization, as a way to avoid the information and incentive problems inherent in government ownership and control, requires private ownership and control. 

1.   E. S. Savas, Privatizing the Public Sector (Chatham, N.J.: Chatham House Publishers, Inc., 1982).

2.   Robert W. Poole, Jr., “Municipal Services: The Privatization Option,” The Heritage Foundation, A New Federation Task Force Report No. 238, January 11, 1983.

3.   Where a service, if provided, will benefit nonpayers as well as payers, each individual has an incentive to “free ride”—to accept the benefits of the service provided by others without paying the cost. This “free-rider” incentive (arising only when nonpayers cannot be excluded) is a major justification for government provision of law and order (including national defense).

4.   Steve H. Hanke, “Privatize Those Lands,” Reason, Vol. 13., No. 11, March 1982.

5.   R. S. Taylor-Radford, “Rush-Hour Remedy,” Reason, Vol. 13, No. 9, January 1982.

6.   Poole, op. cit., p. 6.

7.   Ludwig von Mises, Bureaucracy (New Rochelle, N.Y.: Arlington House, 1969), p. 35.

8.   For a discussion of the adverse effects of the subsidy-masked “low” price of education see: Ernest G. Ross, “The Price of Education,” The Freeman, February 1983.

9.   Robert A. Nelson, “Making Sense of the Sagebrush Rebellion: A Long Time Strategy for the Public Lands” (paper presented at the Third Annual Conference of the Association for Public Policy Analysis and Management, Washington, D.C., October 23-25, 1981).

10.   Savas, op. cit., p. 111.

11.   James B. Ramsey, “Selling the New York Subways,” National Review, February 4, 1983, p. 115.


August 1983

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