You Dont Always Get What You Pay For: The Economics of Privatization

1
You Dont Always Get What You Pay For The
Economics of Privatization
Elliott D. Sclar, Professor of Urban Planning
Public Affairs, Columbia University
2
The Political Economic Context for the Book
3
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 Britains 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.

4
An Intellectual RevolutionSome 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.

5
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.

6
Conclusion Government (whether democratic or
dictatorial) is almost always the problem, the
market is almost always the solution.

• 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.

7
My Findings and Response
8
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.

9
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.

10
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.

11
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.

12
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

13
A Comparison SMM TCE
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The TCE Privatization Rule

• If DC gt CC TC then contract
• IF DC lt CC TC then keep in house
• CC Contract Cost
• DC Direct Cost
• TC Transaction Cost
• Note Even if CC lt DC it does not by itself make
  a case for privatization.

15
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.

16
Two Polar Examples

• Contract out the painting of the City Hall
• Retain the Fire Department

17
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.

18
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 action and that which we expect from
private actions is always fuzzy.
Private
Public
19
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.

20
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 ZXY
• A similar analysis was performed for all the
  elements.
• State estimated the cost to be 4.08 million

21
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.

22
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

23
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.

24
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 doesnt 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.

25
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

26
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.)

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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

28
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.

29
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.

30
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.

31
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.

32
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.

33
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.

34
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.

35
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.

36
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.)

37
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
  IGs.
• At the state and local level it is not uncommon
  to hire outside inspectors to supervise the work
  of public contractors.

38
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.

39
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 cant 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.

40
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.

41
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 .

42
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.