Not more, not less – let’s try to answer it.
Once upon a time…
Maybe I will surprise you, maybe not, but in the 1930s and 1940s, almost all the economists, and in fact almost all of the Nobel laureates, were in favour of government ownership of an industry if only they suspected any market imperfections around. This was so because what was at the centre point of the economic discussion back then was competitive pricing, rather than ownership.
Even laissez-faire economists at that time were accepting nationalisation, if it was to achieve presence of competitive prices. Henry Simons wrote in “A Positive Program of Laissez Faire”: “The state should face the necessity of actually taking over, owning, and managing directly, both the railroads and the utilities, and all other industries in which it is impossible to maintain effectively competitive conditions.”
During the World War II everything that could be nationalised was nationalised. In Europe this tendency was somewhat preserved in the post-war period, when many countries opted for state ownership of strategic sectors of the economy i.e. mines, electricity, heavy industry, food provision etc. An extreme case of such an approach was found in the communist countries of the Eastern Europe, where virtually everything became state-owned.
… and now.
We all know how communist ideas ended up and that the approach towards state-ownership has changed completely – a few decades ago no one would ever suspect that a private bus company could ever be successful. Or garbage collection. Or electricity provision. And they all work!
Today, people usually agree that certain items should be provided by the state, but they still disagree whether they should be produced publicly or privately.
And whereas it is quite difficult to find the adversaries, supporters of contracting-out are as visible as opponents of American troops in Iraq. One can even get an impression that – provided - A - you are not an unionised worker of a state-owned company – B - you are not a politician in a country of dozens of people falling into the category A described above – then probably you should support contracting-out. What would make you think so?
Maybe the following [Shleifer 1998]:
Turkish state-owned coalmining company running annual losses per worker equal to six times the per capita national income.
A state-owned power utility in the Philippines shutting off electricity for seven hours a day in many parts of the country.
A state sugar-milling monopoly in Bangladesh employing 8,000 unneeded workers while forcing the price of sugar in the country to stay at twice the international level.
A Tanzanian state-owned shoe factory which, even with the World Bank’s help, could not get its production to rise above 4 per cent of capacity before shutting down.
If there was no World Bank in the footnote, you would hardly believe it.# When I asked my friends to guess the year in which all these took place, the answers varied from 1950s to 1980s.. In fact, these events all took place in 1995 so not a long time ago.
So it seems that contracting-out is a good idea, right? But is this always the case?
I do not think so. Of course, you can argue that something is always true, but such a statement is highly questionable in a diverse world we live in. What is relevant to apply to one environment may be incredibly foolish to use in some other setting. For instance, I would not recommend having your water pipes installed outside of your house in Alaska, whether in England it is actually a good cost- and space-saving strategy.
Thus, we need to approach contracting-out versus state-ownership dilemma from several different angles to find a general recipe for deciding whether government should contract out a service or not.
First, we will think of the market environment i.e. we will examine the importance of competition and the problem of being incapable of writing fully-specified contracts. Then, we will relax the assumption of the benevolent government and how much impact it has on our discussion. Having done that we should be ready to inspect the simplest cases of the contract-out-do-not-contract-out dispute.
Ready. Steady. Go.
“It’s the competition, stupid!”
Those who favour privatisation over state-ownership often highlight the importance of competition.
Imagine a government setting up a contract, not more, no less, but to contract out a specific service. The minister of infrastructure, who has set up the scheme, is planning to open a bottle of champagne, since after a couple of months she is sure of reaping off the benefits of the presence of competition.
Unfortunately, this is not always the case. Think, for instance, of natural monopolies, where a high fixed cost associated with entering a particular market leads to economics of scale, whereby the average cost of production falls as quantity of output rises. Hence, in equilibrium, there will be only one firm in this market. If this firm goes private, there will be no competitive pressure for this firm to deal with due to the impossible-to-overcome barriers of entry. Then such a firm will under provide at a higher cost to consumers than a state-owned company would normally do. Thus, when thinking of privatisation of industries following this pattern - electricity, gas, land-line telephone providers - one must make sure that competition will be introduced by dividing the company into a few separate ones with managers who would not collaborate with one another, and that specific anti-monopolist laws will be enforced, if service is going to be contracted out to only one company.
Another thing is that competition requires perfect information. This is extremely important, especially when it comes to consumer’s knowledge on cost and quality of a product. Take the very famous dilemmas of whether schooling and medical care should be contracted out. Both cases seem very similar at first glance – the society cannot go on without them, innovation is important, incentives of their state-employed staff are rather weak, and the damage from cost-cutting would be enormous for both of them. What differentiates these two is customers’ access to information. When you choose a primary school for your kids, in many cases it is enough to ask your neighbours for advice. But when you are to choose medical treatment, the case is much more complicated as consumers usually have poor ability to assess the quality of health care they receive [Hart, Shleifer, Vishny, 1998]. In this case, not only is the cost of acquiring information very high (Spending a couple of years doing a degree in medicine is not a cheap business..), but also the cost of making bad decisions is enormous (The stake is often your life!).
Now, take a step back and think why we do actually want competition. Well, this is because individual suppliers fight for their consumers by reducing cost, which can be achieved through innovation. And it is hard to argue against what Alfred Marshall said at the dinner of the Royal Economic Society on the 9th of January 1907: “A government could print a good edition of Shakespeare’s works, but it could not get them written.” Yes, government is generally a poor innovator.
Indeed, entrepreneurship is what makes the economy grow, it is what makes good become better, and expensive - cheaper. Unfortunately, the two usually do not go together. A firm can achieve cost-reduction by lowering product’s quality. Hence, a case in which quality is non-contractible, is generally a case against contracting-out, provided reputation-building mechanisms are non-existent (Would you produce low-quality goods, if you knew that the customers would not buy them again?).
“Power tends to corrupt and absolute power corrupts absolutely” – relaxation of the assumption of benevolent government.
The case for contracting-out is becomes if corruption and patronage enter our calculation. When it comes to the latter, it is rather obvious that trade unions around the world are typically strongest opponents of contracting-out, since they can obtain benefits in exchange for political support. This is a clear counterargument for state-ownership.
As for corruption, it is more ambiguous. On one hand, government provision often puts people in a position to take bribes for obvious reasons. But contracting-out is definitely corruption-free as politicians may award contracts to their friends (Guess of which very famous Vice-President I am thinking right now?) or inefficient providers in exchange for bribes. This is actually quite easy – just write a bad contract that fails to make the firm accountable to quality.
So if corruption may take place no matter if the government contracts out or keeps public services state-owned, the optimal idea may be to rely completely on unregulated market supply. For example, it may be better to have private garbage collection than either by government employees, or that by the private contractors who got their concessions by bribing officials. Also, a good idea may be to make sure that contracts would be awarded by competitive bidding to make sure that no nepotism is present.
To sum up, it seems that public services should be contracted out when innovation is important and, there is no serious damage to quality from cost-cutting, there is relatively good information available on the market, reputation-building arguments are strong, and corruption and patronage – not widespread.
Sources:
A Shleifer (1998), “State versus Private Ownership”, Journal of Economic Perspectives, 12:4, Fall, 133-150.
O Hart, A Shleifer, R Vishny (1998), “The proper scope of government: Theory and an application to prisons,” Quarterly Journal of Economics, 112:4, 1127-1161.
Even laissez-faire economists at that time were accepting nationalisation, if it was to achieve presence of competitive prices. Henry Simons wrote in “A Positive Program of Laissez Faire”: “The state should face the necessity of actually taking over, owning, and managing directly, both the railroads and the utilities, and all other industries in which it is impossible to maintain effectively competitive conditions.”
During the World War II everything that could be nationalised was nationalised. In Europe this tendency was somewhat preserved in the post-war period, when many countries opted for state ownership of strategic sectors of the economy i.e. mines, electricity, heavy industry, food provision etc. An extreme case of such an approach was found in the communist countries of the Eastern Europe, where virtually everything became state-owned.
… and now.
We all know how communist ideas ended up and that the approach towards state-ownership has changed completely – a few decades ago no one would ever suspect that a private bus company could ever be successful. Or garbage collection. Or electricity provision. And they all work!
Today, people usually agree that certain items should be provided by the state, but they still disagree whether they should be produced publicly or privately.
And whereas it is quite difficult to find the adversaries, supporters of contracting-out are as visible as opponents of American troops in Iraq. One can even get an impression that – provided - A - you are not an unionised worker of a state-owned company – B - you are not a politician in a country of dozens of people falling into the category A described above – then probably you should support contracting-out. What would make you think so?
Maybe the following [Shleifer 1998]:
Turkish state-owned coalmining company running annual losses per worker equal to six times the per capita national income.
A state-owned power utility in the Philippines shutting off electricity for seven hours a day in many parts of the country.
A state sugar-milling monopoly in Bangladesh employing 8,000 unneeded workers while forcing the price of sugar in the country to stay at twice the international level.
A Tanzanian state-owned shoe factory which, even with the World Bank’s help, could not get its production to rise above 4 per cent of capacity before shutting down.
If there was no World Bank in the footnote, you would hardly believe it.# When I asked my friends to guess the year in which all these took place, the answers varied from 1950s to 1980s.. In fact, these events all took place in 1995 so not a long time ago.
So it seems that contracting-out is a good idea, right? But is this always the case?
I do not think so. Of course, you can argue that something is always true, but such a statement is highly questionable in a diverse world we live in. What is relevant to apply to one environment may be incredibly foolish to use in some other setting. For instance, I would not recommend having your water pipes installed outside of your house in Alaska, whether in England it is actually a good cost- and space-saving strategy.
Thus, we need to approach contracting-out versus state-ownership dilemma from several different angles to find a general recipe for deciding whether government should contract out a service or not.
First, we will think of the market environment i.e. we will examine the importance of competition and the problem of being incapable of writing fully-specified contracts. Then, we will relax the assumption of the benevolent government and how much impact it has on our discussion. Having done that we should be ready to inspect the simplest cases of the contract-out-do-not-contract-out dispute.
Ready. Steady. Go.
“It’s the competition, stupid!”
Those who favour privatisation over state-ownership often highlight the importance of competition.
Imagine a government setting up a contract, not more, no less, but to contract out a specific service. The minister of infrastructure, who has set up the scheme, is planning to open a bottle of champagne, since after a couple of months she is sure of reaping off the benefits of the presence of competition.
Unfortunately, this is not always the case. Think, for instance, of natural monopolies, where a high fixed cost associated with entering a particular market leads to economics of scale, whereby the average cost of production falls as quantity of output rises. Hence, in equilibrium, there will be only one firm in this market. If this firm goes private, there will be no competitive pressure for this firm to deal with due to the impossible-to-overcome barriers of entry. Then such a firm will under provide at a higher cost to consumers than a state-owned company would normally do. Thus, when thinking of privatisation of industries following this pattern - electricity, gas, land-line telephone providers - one must make sure that competition will be introduced by dividing the company into a few separate ones with managers who would not collaborate with one another, and that specific anti-monopolist laws will be enforced, if service is going to be contracted out to only one company.
Another thing is that competition requires perfect information. This is extremely important, especially when it comes to consumer’s knowledge on cost and quality of a product. Take the very famous dilemmas of whether schooling and medical care should be contracted out. Both cases seem very similar at first glance – the society cannot go on without them, innovation is important, incentives of their state-employed staff are rather weak, and the damage from cost-cutting would be enormous for both of them. What differentiates these two is customers’ access to information. When you choose a primary school for your kids, in many cases it is enough to ask your neighbours for advice. But when you are to choose medical treatment, the case is much more complicated as consumers usually have poor ability to assess the quality of health care they receive [Hart, Shleifer, Vishny, 1998]. In this case, not only is the cost of acquiring information very high (Spending a couple of years doing a degree in medicine is not a cheap business..), but also the cost of making bad decisions is enormous (The stake is often your life!).
Now, take a step back and think why we do actually want competition. Well, this is because individual suppliers fight for their consumers by reducing cost, which can be achieved through innovation. And it is hard to argue against what Alfred Marshall said at the dinner of the Royal Economic Society on the 9th of January 1907: “A government could print a good edition of Shakespeare’s works, but it could not get them written.” Yes, government is generally a poor innovator.
Indeed, entrepreneurship is what makes the economy grow, it is what makes good become better, and expensive - cheaper. Unfortunately, the two usually do not go together. A firm can achieve cost-reduction by lowering product’s quality. Hence, a case in which quality is non-contractible, is generally a case against contracting-out, provided reputation-building mechanisms are non-existent (Would you produce low-quality goods, if you knew that the customers would not buy them again?).
“Power tends to corrupt and absolute power corrupts absolutely” – relaxation of the assumption of benevolent government.
The case for contracting-out is becomes if corruption and patronage enter our calculation. When it comes to the latter, it is rather obvious that trade unions around the world are typically strongest opponents of contracting-out, since they can obtain benefits in exchange for political support. This is a clear counterargument for state-ownership.
As for corruption, it is more ambiguous. On one hand, government provision often puts people in a position to take bribes for obvious reasons. But contracting-out is definitely corruption-free as politicians may award contracts to their friends (Guess of which very famous Vice-President I am thinking right now?) or inefficient providers in exchange for bribes. This is actually quite easy – just write a bad contract that fails to make the firm accountable to quality.
So if corruption may take place no matter if the government contracts out or keeps public services state-owned, the optimal idea may be to rely completely on unregulated market supply. For example, it may be better to have private garbage collection than either by government employees, or that by the private contractors who got their concessions by bribing officials. Also, a good idea may be to make sure that contracts would be awarded by competitive bidding to make sure that no nepotism is present.
To sum up, it seems that public services should be contracted out when innovation is important and, there is no serious damage to quality from cost-cutting, there is relatively good information available on the market, reputation-building arguments are strong, and corruption and patronage – not widespread.
Sources:
A Shleifer (1998), “State versus Private Ownership”, Journal of Economic Perspectives, 12:4, Fall, 133-150.
O Hart, A Shleifer, R Vishny (1998), “The proper scope of government: Theory and an application to prisons,” Quarterly Journal of Economics, 112:4, 1127-1161.
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