Wednesday, February 27, 2002

Elliott D. Sclar, Professor of Urban Planning &Public Affairs,Columbia University

Prepared for PRMPO & SDV,World Bank,Washington DC

You Don’t Always Get What You Pay For: The Economics of

Privatization

The Political & Economic Context for the Book

The political conventional wisdom in support of privatization and deregulation can be traced to some

key events of the 1970s and 1980s: Some Stylized Facts

• The U.S. economy began to lose its post world war two steam in the early 1970s:– “Stagflation”

– Slow down in real rate of GDP growth after 1973.

• Great Britain’s economy was hammered by labor strife.

• “Los Chicago Boys” brought an “apparent” economic miracle to dictatorial Chile.

• Central Planning Collapsed in Eastern Europe.

• Thatcher and Reagan carrying a bundle of laissez faire policies moved from stage right to center stage.

An Intellectual Revolution:Some Stylized Facts

• Laissez faire thinkers were producing a powerful body of analysis challenging the intellectual underpinnings of the welfare state that emerged in the early decades of the 20th Century. – Nisbet, Hayek, Friedman, et. al. made the strong

general case for markets and democracy.• “The government that governs least, governs best.”

The Political Economy Case

• The Standard Market Model makes the strong economic case for decentralized decision making and disempowering government.– “Pareto Optimality.”

• Public Choice makes the strong political case for the incompetence of government.– “Rent Seeking Behavior.”

• Neoliberalism is the name for the body of policy theory that emerged in the 1980s. It combines public choice and Pareto Optimal arguments into a case for market governance.

• Privatization is the rubric for the series of public policies that emerged that were intended to deregulate industries and bring more private sector participation into the delivery of public goods.

Conclusion: Government (whether democratic or dictatorial) is almost always the problem, the market is almost

always the solution.

My Findings and Response

My experience: A disjuncture between theory and practice.

• I began studying privatization of American public services in 1987.

• I fully expected to find that the results would be consistent with the predictions of theory: i.e. “better” and/ or “cheaper.”

• The contrary findings were as numerous (if not more so) than the consistent ones.

• The rejoinder was always the same:– Failure occurred because the public sector performed the

privatization incompetently.

The need for a better theoretical basis for public policy

The reasoning was tautological: The public sector needed to privatize because it was less competent than the private sector and the privatization did not work because the public sector was incompetent. That was not an intellectually satisfying answer.

My conclusion: markets are useful servants but terrible masters. Is there a conceptual basis for putting this into practice?

• Neither public choice theory nor the standard market model provide adequate explanatory power for the actual complexity of public contracting. Most obviously:– Rent seeking is neither restricted to public officials nor

their only motivation. – Contract prices are limited in the amount of useful

information they convey because goods are complex.

• Hence these formal theories, devoid of substantive institutional content, are at best suggestive and often wrong as guides to privatization policy.

Ad hoc rule making is both inefficient and unsustainable.

• An ironic outcome of the pressure to privatize is that the costs of government do not decrease as, the model predicts.

• The more we rely on contracting the greater will be the pressure to increase both public rule making and public supervision of the businesses of public contractors.– Both very costly.

• Why does this happen?…..– We are ignoring the transactions costs of the process.

Towards an Improved Theoretical Basis for Public Policy

• Start from a Coaseian premise:– There is a transactions cost to using the market.– Therefore privatization should hinge on the relative

costs of the market in comparison to the costs of bureaucracy.

• The transactions cost of using markets will vary directly with – The general functionality of broader social institutions

(The more functional the society, the lower the costs.)

• The need for institutional analysis

– The unique attributes of the public good in question.• The need for transactions cost analysis

A Comparison: SMM & TCE

Analytic

Model

Key

Variable

Rationality Knowledge Motivation

SMM Price Hyper Complete Self Interest

TCE Transaction Bounded Incomplete Self Interest + Guile

The TCE Privatization Rule

• If DC > CC + TC; then contract

• IF DC < CC + TC; then keep in house• CC = Contract Cost

• DC = Direct Cost

• TC = Transaction Cost

• Note: Even if CC < DC it does not by itself make a case for privatization.

Transactions Costs Economics

• All other things being equal:– The more frequent the number of

interorganizational transactions,– The more uncertain the characteristics of

product quality– The more highly specific the assets used to

produce the output

• The lower the cost of direct production.

Two Polar Examples

• Contract out the painting of the City Hall

• Retain the Fire DepartmentService Freq.

TransactionProduct Quality

Asset Specificity

Painting

City Hall Low

Clear Low

Fire Dept.High

Uncertain High

Institutional Analysis

• The previous examples rested upon a complex set of assumptions about contract law and property rights that are by no means universal.

• It is increasingly the case, especially when privatization is considered in varying cultural contexts, to understand the social, political, and legal institutions in which these public private contractual relationships are to be embedded.

What is Public? What is Private? These are not static.It is like aiming at a moving target

The line between that which we expect of government actionand that which we expect from private actions is always fuzzy.

Public

Private

MassHighway: A Case Study

• Highway Maintenance: A Good Privatization Candidate:– Virtually all states have a variety of public and private providers.– It appears to pass the “yellow pages” test.

• In 1992 Massachusetts Gov. Weld decided to proceed with a privatization of the entire system and shut down the state highway department (MassHighway)

• It was to be carried out in sections. The first section was Essex County in the northeastern section of the state.

• The Essex County experiment produced a great deal of data and thus becomes a good case study of many of the issues.

The Process

• The Commonwealth conducted a series of studies and estimated the per unit cost of the various elements of the maintenance task.– $Z per liner foot to sweep roads– X number of feet– Y times per year– Total Cost = $Z*X*Y

• A similar analysis was performed for all the elements.

• State estimated the cost to be $4.08 million

The Bidders and the Bids

• “Yellow pages” were not relevant as state was seeking a single firm for all the tasks

• Effective market came from existing highway contractors.

• Bid prices ranged from $3.7 M to $8.1 M• Winning bidder began work in October ’92.• Five months later Weld Adm. declared the

experiment a success and spread it to the rest of the state.

The Aftermath

• The Weld declaration set of a political fire storm.– The legislature investigated the Essex County

experience.

– The State Auditor also investigated

– The Administration hired Coopers-Lybrand.

• The conclusions differed greatly:– OSA found they lost $1.15M

– Coopers concluded they saved $2.5 M

The Findings

• Despite the care taken by the Administration in estimating the contract cost they paid little attention to estimating the pre contract costs.

• The contract was “incomplete.”– Public employees and equipment were given to the

contractor– Moral hazards abounded.

• It is impossible to accurately determine if it really saved or actually lost money.

• My own sense is that it is marginal either way.

Privatization is premised on a misperception of the economics of public contracting.• The actual markets for public contracts typically

fail to measure up to the competitive ones predicted by the simple supply/demand models that privatization advocates use to spin their policy proposals.

• To many of them this often doesn’t matter as their advocacy is powerfully rooted in an anti-government ideology and not a concern for efficient public service.

• But for those of us who believe that the mission of government is to provide the best possible public services at the lowest possible cost, then getting the economic theory right is important.

Public contracting differs from private contracting in three major ways.

– Rule bound procedures• The need for transparent accountability necessitated by the

expenditure of public money means that public contract bidding and oversight rules are more stringent and complex than private contracting. (The red tape factor.)

– Lobbying• Contractors and other interested parties can always go around

decision makers to get the rules of the game changed.

– The distribution of risk, especially for public goods and services that do not carry a market price is never straightforward.

• Cost Plus vs. Fixed Price Contracts

Transaction costs are the source of significant public sector costs.

• Transactions costs include:• The costs of administration of the contract bidding

process.• The costs of contract management and supervision.

• They are difficult to estimate but real and significant.

• Typically when a contract fails it is because of the transactions costs (Often perceived as a “hassle factor” or an “aspirin factor.”)

Forms of Transactions Costs

– Information Costs – Lack of or unequal information between parties to a transaction (information asymmetry)

– Agency Costs – Divergence in mission between principal and agent– Costs of Shirking – The employment contract– Opportunism – Parties act with self interest– Costs of Uncertainty – Lack of knowledge about future conditions

• Risk Premiums• Insurance Costs

– Adverse Selection – The worst comes first– Moral Hazard – Conflict of interest– Costs of Compliance

• Costs of measuring performance• Detecting Violations• Imposing Penalties

– Costs of Imperfect tools of Measurement

Privatization is a complex notion.

• It involves long term contracting.

• Long term contracting is often “incomplete contracting.”

• As a result contracts are neither self enforcing nor easily enforced at low cost.

• There is no simple “remote control” method to improve government performance.

Third party governance is a direct manifestation of privatization. According to a 1999 study* there were 1.9 million

federal employees (civil service and political appointees) and 8 million people employed on federal grants and contracts.

This is a result of the fact that a bi-partisan Congressional consensus emerged to seek to cap the size of the federal work force. (Ideology)The story at the state level is similar.

• Paul Light “The True Size of Government” Brookings Institution, 1999.

Lowering the transactions costs of privatization should be a priority.

• Clarify the public policy purposes behind the use of deregulation and contracting.

• Standardize the cost and quality comparison protocols.• Clarify liability and risk issues.• Strengthen public accountability.• Oversight must be made a clear public sector

responsibility.• Tighten procedures for preventing and prosecuting fraud

and abuse.• Strengthen the firewall between politics and public

contracting.• Appreciate the role of public employees.

Clarify the Public Policy Purpose of Privatization

• The case for privatization must be proven and not asserted.– Some state enabling legislation assert that

private is better (Arizona).– Others require a demonstration

(Massachusetts).

• In light of the underlying economics it is reasonable to seek legislation that carefully specifies when it can appropriately be used.

Standardize the cost comparison protocols.

• There is a great deal of sloppiness, some inadvertent, but much intentional in the rules by which cost comparisons are done.

• Typically full allocated cost comparisons are mandated.

• Cost comparisons should always rely heavily on “avoidable cost” analysis.

Ensure that competition exists to the extent possible.

• Public contracts should contain a “most favored nation” clause to ensure that contractors always give each agency the lowest possible price. – To minimize impact of information asymmetry and adverse

selection.

• Decisions to privatize should involve a good faith effort to ensure that the change dynamics of the industry resulting from privatization will neither undermine medium and long term competition nor the public mission.– Industry consolidation in the aftermath of privatization is not

uncommon.• Buyers love competition but sellers hate it.

– The mission of the buyers and sellers can and often are contradictory and not complimentary.

Standardize the quality comparison protocols.

• The product to be contracted must be carefully and completely specified.– Change orders are expensive– Contractors act with self interest and guile– Information is often incomplete and

asymmetric.

• Massachusetts highway maintenance as a case in point.

Clarify liability and risk issues.

• A principal purpose for contracting is to shift risk from the public sector to a private provider.– Typically a fixed cost contract for a highly specified

good in which the contractor assumes the risk for nonperformance and liability for malfeasance or misfeasance.

– But public service quality is often difficult to measure. Hence contracts are often cost plus. This shifts much of the risk for cost back to the public agency.

• Prison privatization as a case in point.

Strengthen public accountability.

• Civil Service rules need to be extended to contract employees.– Private employees in the public service are exempt

from conflict of interest rules, rules about openness and pay limits.

• Public accountability needs to be extended to private contractors. – Freedom of Information rules must cover the work

done by private contractors for public agencies. This is especially the case where it forms the basis for an official decision. (Program eligibility, etc.)

Oversight is and must remain an unambiguously clear public sector

responsibility.

• The work of private contractors must be under the constant supervision of competent publicly employed examiners.– At the federal level there is pressure to contract

out work carried out by Departmental IG’s.– At the state and local level it is not uncommon

to hire outside inspectors to supervise the work of public contractors.

Tighten procedures for preventing and prosecuting fraud and abuse.

• Contracts must specify the conditions and maintenance terms for the use of any publicly owned property by private contractors.

• Create a national registry of all firms and principal owners who do business with public agencies.– This registry should list all instances in which either the

firm or its principal has been convicted of fraud, been involved in litigation with a public agency, or pled “no contest” to charges leveled against them.

• Individual decision makers would be free to use this information as they pleased.

Strengthen the firewall between politics and public contracting.

• Privatization requires that public markets be made as efficient as possible.

• But Public Markets Invite Influence peddling.• Needed Reforms:

– Contractors can’t be involved in donating $ to political campaigns.

– Jam up the revolving door.

– Violators should be personally liable for their actions.

– Establish a registry of public contractors that lists convictions and

plea bargains for violating public contracting rules.

Public Employees as Public Assets

• In the public sector, its capital effectively walks out the door every night.– Public employees are the repository of all the expertise

that the public sector has to serve the citizenry.

• Worker protections in the public sector must be extended to those doing public work in the private sector.

• Living wages or union wages must set the norm.• Legislatures must set clear rules on worker

replacement.

Make Meaningful and Early Employee

Participation Possible • If “best practice,” as the preferred alternative, is to

add to productivity or to cut costs, employees must be integral to the reorganization process.

• “Sink or Swim” is wrong.• Can be done is several ways:

– Direct bidding– Labor-Management Cooperation– Some Combination

• Improvement takes Investment of Time and $.

Rules must require that agencies

always compare three choices • Service delivery by the public sector as it

exists;• Service delivery by the private sector as

it is likely to exist, allowing for probable contingencies;

• Service delivery by the public sector, as it can feasibly be improved, including appropriate public-private partnerships.