Privatization: Is It the Answer? E. C. Pasour, Jr.

This growing interest in the appro priate role of government coincides with the "privatization" movement. Privatization involves the exten sion of market principles to goods and Dr. Pasour is Professor of Economics at North Caro lina 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. 462 services currently financed and/or produced by government. Relying on mounting empirical evidence, it suggests that many activities cur rently performed by government could better be done by private firms. This paper explores the advantages of privatization and the limits of half way privatization measures which are not rooted in private property and private control. In his recent book, Privatizing the Public Sector, E. S. Savas cites evi dence that private companies rela tive 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 govern ment. Four of the most important ways of increasing the role of mar ket forces in the delivery of goods and services are contracting out, franchises, user fees, and "load shedding."

PRIVATIZATION: IS IT THE ANSWER? 463 MarketProcesses In contracting out such activities as refuse collection and fire protec tion services, government remains responsible for financing but selects one or more providers through com petitive bidding. In contrast, an ex clusive franchise is an award of mo nopoly 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 pro vided as franchise services. Whereas government pays the producer for services contracted out, the con sumer pays the producer for fran chise 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 ex ample, a number of cities have insti tuted specific fees to pay exclusively for garbage service. 2 The use of user charges is technically feasible wher ever nonpayers can be excluded from the use of a good or service. 3 Finally, "load-shedding" is com plete privatization where govern ment bows out and allows the pri vate sector to produce the service and offer it directly to consumers. An ex ample is municipal refuse collection where towns and cities get com pletely 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 pri vatization? Most people value the freedom to choose, and competition among suppliers of goods and ser vices 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 tor agencies constitute wasteful duplication. It is the thesis of this paper that increased market com petition 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 gov ernment is now dominant including mail services, education, Social Se curity, and other areas where com petition, if not prohibited, is at least inhibited. In so far as it serves to increase competition, privatization has the potential to reduce the stul tifying effects of government provi sion and production of goods and services. Consider some of the prob lems inherent in government fi nancing and production of goods and services.

464 THE FREEMAN August 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 pri vately 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. Conse quently, financial considerations in duce 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 govern ment provision of education (educa tional financing) does not imply gov ernment production of educational services (government-run schools). A failure to maintain the distinction between government financing and government production has un doubtedly 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 spend ing too little on these activities, shortages merely reflect prices arbi trarily set too low on the basis of current supply and demand condi tions. 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 transporta tion, 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 ser vice. 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 govern mental services at the local or state level is increased by "revenue-shar ing" arrangements where citizens, ostensibly at least, can obtain a larger amount of goods and services for a given outlay.

1983 PRIVATIZATION: IS IT THE ANSWER? 465 Of course the "shared revenue" involves a cost, but it is largely borne by other taxpayers. Communities which forgo revenue sharing and fi nance services on their own must pay twice--"-once through taxes to sup port 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 gov ernment has a financial incentive to "get its share." Second, even when financing oc curs fully at the state, local, or fed eral 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 considera tions or equity reasons. There is a strong feeling on the part of many people that water, education, and other "necessities" should be pro vided below cost to assure that the service is provided to lower-income groups. In addition, since the quan tity demanded of a product is greater the lower the price, there are advan tages both to political incumbents and to government employees in pricing goods and services below cost.

Thus, water, museums, recreational facilities, governmental publica tions, and other collectively pro vided goods and services are fre quently 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 read ily be excluded, for a wide variety of government activities including such services as roads, bridges, airport landing rights, elementary, second ary, 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 improve ments 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 identifi cation 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 tradi tionally provided by government, incl uding fire protection, mail ser vice, health care, and garbage col lection. In the case of garbage collec tion, for example, contracting out of residential collection has shown im pressive savings: "Nationwide stud ies in the United States, Canada, and Switzerland, as well as regional studies in Connecticut and the Mid466 THE FREEMAN August west, have shown that government garbage collection is 29 to 37 per cent more costly than private con tract collection."6 Thus, even if "load shedding" is not achieved, improve ments can be made in the produc tion and pricing of many govern ment services.

Limits of Increased Efficiency As shown below, however, it isn't possible to achieve the full advan tages of "load shedding" -of private provision and production in decen tralized markets-through the use of user charges, contracting out, franchise, and other halfway pri vatization measures. That is, there are limits in the extent to which the advantages of decentralized mar kets can be achieved in government provision and production, or in gov ernment monitoring of goods and services produced under contracting out and franchise arrangements. Attempts to apply market meth ods to the provision and production of goods and services produced un der the aegis of the state must over come inherent information and in centive problems. Consider first the information problems confronting taxpayers and other citizens in mon itoring 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 objec tive way to evaluate prices of gov ernment 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 gov ernment 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 entrepre neurial decisions. And, since the fu ture is always uncertain, there is no reason to expect the outside ob server 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 pro duction of goods and services are no less formidable than the informa tion problems just discussed. In competitive markets, decisions are made on the basis of expected profits or losses, and the conduct of the en trepreneur is constrained by profit considerations. In order to reap fi nancial rewards, the private entre preneur must successfully antici1983 PRIVATIZATION: IS IT THE ANSWER? 467 pate consumer wishes and satisfy them at a competitive price. The market process provides an incen tive 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 dis cretion. 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 col laborators in order to replace them by incompetent personal friends or rela tives. His conduct is subject to the incor ruptible judgment of an unbribable tri bunal: the account of profit and 10ss.7 The situation is likely to be quite different under government financ ing, production, or monitoring. Gov ernment agencies are generally not profit-seeking enterprises, and profit and loss considerations have rela tively little effect on production and marketing decisions. That is, bu reaucrats and politicians do not face incentives that foster good perfor mance. The results of central plan ning whether for land, garbage col lection, production of electric power, or for the entire economy are clear.

Resources publicly owned or con trolled cannot efficiently accommodate consumer wishes when con trasted with private ownership and control. Even if information problems could be overcome, incentive problems would prevent the efficient use of re sources allocated through central direction. 8 In contracting out or franchise arrangements, for exam ple, 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 wind fall gains to the firm obtaining the franchise provide an incentive for firms to engage in bribery and other "rent-seeking" activity and for pub lic officials to respond. Furthermore, firms operating un der profit controls have an incentive to use the controls to their own ad vantage. In the case of a firm oper ating under government franchise where price charged is to be based on production cost, for example, management has an incentive to in flate costs by padding expense ac counts, by taking expensive busi ness trips, and by taking returns in the form of such nonmonetary per quisites as lavishly decorated offices including thick carpeting, expensive furniture, expensive paintings, and so on.

468 THE FREEMAN August Similar information and incentive problems are also endemic in the "scientific" approach to manage ment of public land. The aim of the early conservation movement in the United States was to introduce "sci entific management" into govern ment. 9 If government is to function efficiently, according to this view, politics must be confined to specify ing general policy directions, leav ing the actual administration to skilled professionals. In view of the information and incentive problems inherent both in government pro duction and in governmental moni toring of private production, wide spread dissatisfaction with the results of "scientific management" of rangelands, forests and other pub licly owned lands is not surprising. Conclusionsand Implications Savas, after analyzing a number of studies comparing public and pri vate provision of services, concludes that" ... those who believe on a priori grounds that private services are best can find considerable support for their position."l0 Information and incentive problems are endemic in all non-market production and fi nancing arrangements. First, as de scribed 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 automati cally conveyed between producers and consumers through market prices.

Second, in the provision and pro duction 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. Ram sey, in making a case for the priva tization of the New York City sub way system, emphasizes the incentive problems inherent in pub lic ownership: Private management is far more effi cient 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 in centives 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 de cisions 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 ad vantages of competitive markets in government provision or production of goods and services. While shifting productive activities from the fed eral to state or local governments along with the adoption of user fees, 1983 PRIVATIZATION: IS IT THE ANSWER? 469 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 informa tional advantages of load shed ding-that is, of decentralized com petitive markets.

Competitive markets are rooted in private property, and there is no way to simulate competitive conditions under conditions of government fi nancing 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 calcula tion 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 short ages and surpluses, by contracting out and franchise arrangements, or by other halfway privatization measures, there is no reliable benchmark against which to com pare governmentally produced goods and services in the absence of pri vate 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 mar kets. Privatization, as a way to avoid the information and incentive prob lems inherent in government own ership and control, requires private ownership and control. ® -FOOTNOTESlE. S. Savas, Privatizing the Public Sector (Chatham, N.J.: Chatham House Publishers, Inc., 1982).

2Robert W. Poole, Jr., "Municipal Services: The Privatization Option," The Heritage Foun dation, A New Federation Task ForceReport No. 238, January 11,1983. 3Where 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 with out paying the cost. This "free-rider" incentive (arising only when nonpayers cannot be ex cluded) is a major justification for government provision of law and order (including national defense). 4Steve H. Hanke, "Privatize Those Lands," Reason, Vol. 13., No. 11, March 1982. 5R. S. Taylor-Radford, "Rush-Hour Remedy," Reason, Vol. 13, No.9, January 1982. 6Poole,op. cit., p. 6. 7Ludwig von Mises, Bureaucracy (New Ro chelle, N.Y.: Arlington House, 1969), p. 35. 8For 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.

9Robert 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 Pub lic Policy Analysis and Management, Washing ton, D.C., October 23-25, 1981). lOSavas,op. cit., p. 111. llJames B. Ramsey, "Selling the New York Subways," National Review, February 4, 1983, p.115.