Bringing Efficiency to the Third World Through Private Provision ofPublic Services

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Bringing Efficiency to the Third World Through Private Provision ofPublic Services

November 20, 1989 21 min read Download Report
Acting Senior Vice President, Research
Kim R. Holmes, oversaw the think tank’s defense and foreign policy team for more than two decades.

(Archived document, may contain errors)


739 November 20,1989 BRINGING ETFIClENCY TO THE THIRD WORLD THROUGHPRIVATE PROVISION OF PUBLIC SERVICES X+4l7E8DU6T1ON Less developed countries today face the challenge of trying to raise their living standards while contendi ng with debt burdzns and economic stagnation. The resultant need to hold the line on government spending threatens to hinder the delivery of many essential services. Yet this should not be viewed as a catastrophe. To the contrary. The situation offers les s developed countries an opportunity to adopt policies that will deliver these services more efficiently and, at the same time, ease the pressure on government budgets. The way to do this is by creating the mechanisms and incentives for the private sector to provide these services that now are supplied exclusively by government bureaucracies.

That this can be done is now beyond dispute. The private provision of public services has proved successful in most of the developed world and is attracting the attention of many less developed countries.

Public Goods. In a free market economy, most goods and services can be provided by individuals and businesses. Yet those who wish to increase governments role in the economy often maintain that certain sectors must be the responsibility of the state. Water and roads, for example, are said to constitute a natural mouopoly where only one supplier is possible or where muhipie suppliers would be inefficient. Street lighting and national defense it is said, cannot be finan c ed by charging a fee to individual users. Some services, s-uch as education, zire believed to be good for society as a whole, yet might not be adequately supplied at market prices. In such sectors, it is inaintzined, governrllent must provide the good or service, often using taxpayer funds as the source of finance.

Yet public provision has serious problems. Because there is no market competition with the government supplier, and because taxpayer funds can MARKET be used to cover expenses, there is insuffic ient incentive for such suppliers to be efficient or to render the best service possible to the customer In less developed countries, the problem has been especially serious. With fewer avenues for personal advancement, jobs in state industries are much s ought-after and are then protected by those who have them and by the political leaders they support. Corruption and bribery commonly result.

Further, these inefficient state industries often are money losers, requiring billions of dollars in subsidies A si gnificant part of theThird World debt goes to cover such losses wholesale and retail marketing, and the production of consumer goods, the private sector can be the best supplier. Governments would do well to keep out of these areas and privatize all such s tate-owned enterprises In areas where the state feels it necessary to be involved, market forces can be brought to bear for the private provision of public services. Example governments can contract with private firms to construct roads, public facilities , and similar capital assets. Private companies' can maintain and clean public buildings and administer state facilities In the case of a public utility like water, a long-term monopoly franchise can be granted to a private firm.

Services such as education can be provided by private schools with the government issuing vouchers to citizens to pay the fees of the institution of their choice. And private citizen cooperatives can be established to oversee and pass along savings for pu b lic utilities such as electricity strengthening of market forces. The private provision of public services however, is especially useful for less .developed countries in which a weak service sector hinders economic development. Private provision of servic e s can help countries suffering from economic inefficiency, poor infrastructure costly government budgets, and huge debt burdens The United States Agency for International Development AID which is charged with promoting economic growth in less developed co u ntries, as well as such international development organizations as the World Bank, Inter-American Development Bank, and African Development Bank, should make privatization of state-owned enterprises a central element of their general development policies A s important, when some state involvement is still required, these organizations should encourage private sector involvement wherever possible.They can do this by providing information on the successful privatization of public services and by not funding p u blic sector providers that compete with private providers in less developed countries Bringing In Market Forces. In such areas as public transportation All countries' economies can benefit from the introduction or 1 FOR GOODS AND SERVICES Societies need n u merous goods and services. These include food, shelter clothing, electricity, running water, transportation, education, entertainment police protection, and law courts to name but a few. In a market system individuals or businesses produce goods and servi ces which they trade for 2 other goods and services.Thus the quantities and prices of goods and services on the market are the result of all the individual acts of buying and selling.

Customers seek the best values from competing suppliers, while suppliers attempt to make the best possible deals with customers.

Some governments, however, feel it is necessary for certain goods and services to be produced or consumed by the state In Western society these services traditionally have included police protection, law courts, and armies.

The government uses taxpayers money to produce these services. The government in a sense is also the consumer of these services, which it utilizes to maintain an orderly society. The quantity of these services is determined not b y the market demand but rather by political decisions ARGUMENTS FOR GOVERNMENT INVOLVEMENT There are a number of reasons why it is believed that the state rather than the private sector should produce or consume certain goods or services in addition to po l ice and legal systems. These include 1) Natural Monopolies Some services, it is maintained, can be suppliedonly by means of source or a factor of production that cannot be duplicated. A citys water supply, for example, may come from just one source. In su c h circumstances, a private owner of the water source would not face direct competition; he would therefore, be able to exploit those who want water by charging prices considerably higher than his costs of extraction and distribution. A public agency provi ding water in this situation, however, would be politically responsible to the beneficiaries and would do so at nonmonopolistic prices.

I 2) Economies of Scale The efficiency of an enterprise can often be increased by enlarging its scale of production. Usi ng costly specialized equipment, for instance, might be profitable only for large production runs; or inputs for a business might be purchased more cheaply in large quantities. If economies of scale are so great that only a few firms, or perhaps only one, can operate profitably in a given market, there is a danger of monopoly power. Some economists cite early electrically powered public transportation systems that required a single expensive electrical generating system as an example of such an industry.

I 3)Externalities Cases frequently occur when buyers and sellers who exchange goods and services create costs and/or benefits, usually called externalities, for people not directly involved in the exchange. A widely recognized negative externality, for ins t ance, is the pollution caused by factories or automobiles while a positive externality would be the beautiful gardens enjoyed by nonpaying passers-by. Some economists argue that, in the absence of government ownership or control, there is overproduction o f goods or services involving negative externalities and underproduction of those 3 involving positive externalities. Some suggested remedies include taxes to discourage negative externalities and subsidies to encourage positive ones 4) Inability to Charge , or the Free Rider Problem Some goods and services have to be provided to a group as a whole and cannot be subdivided for the benefit of particular individuals. Typical are national defense, street lighting, lighthouses, and conventional radio or TV broad c asting, often called pure public goods. The same level of service is available to everybody, regardless of the extent to which each individual chooses to avail himself of it.There is no way, it is claimed, by which individuals can be charged for the servi ce, or excluded for nonpayment.

Because of the impossibility of charging, or of excluding nonpayers, the private market would not find it profitable to supply these pure public goods.

Hence, it is said, the government must act to ensure their provision.

I 5) Merit Goods Economists use the term merit goods to describe goods and services thought to enhance society as a whole that, if left to private markets, would be produced or consumed in insufficient quantity. The assumption is that many people would sp e nd money on immediate needs and neglect long-term betterment for themselves or their children. Health and education are often thought of as merit goods, at least up to a certain level. As people might not voluntarily buy sufficient merit goods, it is sugg e sted that they should be provided free by public agencies THE PROBLEM OF GOVERNMENT FAILURE When private markets cannot by themselves provide the range, quality, or quantity of services considered desirable, governments often consider alternative methods. One alternative might be direct production of a good or service by government employees such as policemen, mail carriers, and public health experts. Yet, the possibility of government failure as well as market failure, must be considered. The private mark et may be faulty, but the government remedy is often worse.

First, governments tend to make decisions concerning public enterprises based on political considerations, granting favors to one interest group at the expense, and to the detriment, of another interest group or of society as a whole.

Second, because such enterprises are in fact government monopolies, they suffer many of the same problems attributed to private sector monopolies.

Due to lack of competition, government enterprises are prone to inefficiency.

Employees have insufficient incentive to provide the best service possible to customers.

Third, lack of competition often leads to huge financial losses, which taxpayers are forced to cover. The need of governments in poorer countries to cover billions of dollars in such losses from their budgets has diverted 4 enormous resources from other c r ucial social needs and contributed to huge debts In Argentina, for example, the state railroad requires a subsidy of $3 million per day Fourth, because taxpayers ultimately cover such losses, and because of the considerable political power of workers empl oyed in government enterprises such enterprises rarely shut down even when they fail to meet public demands.

And fifth, government economic forecasts are usually based on relatively few scenarios or projections of demand and &e divorced from market process es. Thus government management of any given industry tends to be based on incomplete or outdated information. For example, the Indian Railroad Board failed for 25 years to come anywhere near the correct 1 projections for how much coal to carry. Railroad o fficials explained to a commission of inquiry that their projections were based on official government economic forecasts.

In contrast to government enterprises, the private sector, taken as a whole, has an excellent information base. Market prices, the re sult of all economic exchanges in an economy, communicate information concerning the real demand for goods and services and the costs of producing them. Private provision, subject to market forces, thus helps to determine the real costs of goods and servi c es. Further, the private provision of public goods and services introduces competition and thus avoids many of the problems of government monopolies. Services must meet customer demands and therefore tend to be of appropriate quality. And production tends to be in the most cost-effective manner Thus, production of goods and services by state enterprise, especially in less developed countries with extensive government regulation of the economy, usually would be better left to the private sector. Returning s u ch enterprises to private citizens is often wise. Governments therefore would do well to become involved only in sectors where there is virtually no possibility of private provision. Yet even when the government still desires a role in a particular sector , it is possible to keep the private sector and market forces involved in the provision of public services METHODS FOR PRIVATE PROVISION The private provision of services can be carried out in different ways 1) Contracts from Public Agencies In some situat i ons, government is responsible for a certain sector and including I wishes to own and operate the material assets necessary to provide the required service to the public.The government also may wish to finance the service out of general tax revenues.Typic a 1 of such a sector are transportation infrastructure, government buildings, and military hardware. Yet even here 5 market forces can lead to greater efficiency if the government contracts out to the private sector to provide the service. Road and building maintenance for example, is carried out by private contractors in numerous countries.

These contractors are selected by a process of bidding on the basis of work specifications prepared by the road or building authorities In some U.S. and British cities, private companies are paid to provide bus services 2) Monopoly Franchising Where natural monopolies or problems of economies of scale are believed to exist, a private company can be appointed by a public authority to provide services on a monopoly basis. U nder such an arrangement the government defines the level and kinds of services to be provided, to whom the services must be offered, and the means by which the prices for the services will be determined.The company is required to make the capital investm ents necessary to provide the service.

Private companies compete for the monopoly contract. The winner of the competition has autonomy over the day-to-day operations of the enterprise.

The contract would be for a sufficient length of time to allow the bus iness to meet expenses, realize a return on large capital investments, and make a profit. Periodically the contract would be up for renewal. Other businesses could bid on the contract at these times.This would provide an incentive for the businesses with t he monopoly contract to provide the best possible service to the customers. The provision of piped water in France is one example of such a contract. Another is a contract by the government of Indonesia with a private firm to run the countrys customs serv i ce 3) Management Contracts When the government owns the material assets needed to provide a service and pays for the service from general revenues, it is still possible to introduce market discipline through management contracts; Rather than government em ployees running an operation, private companies bid for the opportunity.

The winning private company provides the personnel to perform service functions in exchange for a set fee from the government. Employees are hired, promoted, and dismissed by the priv ate contractor. New capital investments are still the responsibility of the government. In the U.S many urban bus companies are municipally owned but operated by private management firms. Also in the U.S the private Corrections Corporation of America oper a tes prisons for state governments 4) Vouchers Vouchers constitute an array of systems that enable consumers to get free or reduced-cost goods or services while retaining the power of choosing between competing suppliers. Usually, the government gives indi v iduals a voucher, worth a certain amount of money, which the recipient must spend to secure a certain service. After the individual gives the voucher to a private supplier or even a competing public supplier of his choice, the supplier turns it in to the g overnment in exchange for its value in cash 6 The vouchers best known in America are Food Stamps, which enable the poor to receive subsidized food directly from private supermarkets. This means the government does not have to open special low-price food s h ops An earlier example of vouchers were the cash grants given to discharged GIs after World War 11, which they could spend at any approved higher educational establishment of their choice. Housing vouchers today are used in Britain and in the U.S. to enab l e low-income individuals to obtain rental accommodations at free market rents I 5) Consumer Cooperatives Consumer cooperatives, which range in size from a few dozen to hundreds of thousands of members, are self-governing, voluntary organizations run by th e ir members. Unlike shareholders companies, which distribute surpluses in proportion to share ownership, consumer cooperatives distribute surpluses to members in proportion to their purchases. The consumers themselves ultimately control the policies and ma n agement of the coop. Designed to serve the interests of their members, consumer cooperatives are particularly acceptable in monopoly situations, like village electricity, where consumers may not be able to benefit from competition among suppliers EXAMPLES OF PRIVATE PROVISION Water Supply In many times, places, and circumstances, the private provision of water for drinking, cooking, washing, and industrial use has been the rule In pre-industrial times, vendors carried water from a river or lake for sale to consumers. Yet in industrialized or more economically complex societies problems arise In some cases, only a single water source, perhaps a lake, is available. If a single business controls access to the lake it is feared that a natural monopoly might exi s t with no competing water suppliers and no alternative source. To supply water through pipes, moreover, in many cases is so massive and expensive an undertaking that competition for customers might make it impossible for any suppliers to operate. Negative externalities also might exist, such as individuals depleting a common supply. Finally clean water, free of disease-causing bacteria, might be considered a merit good for society In the case of ground water extraction from wells, the danger is that, if al l wells tap a single source, no user will have an incentive to conserve water. As with children using straws to drink from a single glass, the one who drinks slowest gets the least.

The problems caused by the private extraction of water could be avoided by following the example of the oil industry. Through the use of contractual arrangements and rules, many different operators can pump oil from a single source. Such arrangements might be developed for water 7 Concession System. In the case of extracting wa t er from a single source that cannot be divided, or where separate distribution systems are too expensive, market mechanisms still can be employed In France, many municipal areas grant monopoly concessions to private suppliers for the extraction and distri b ution of water In the concession system, the public authority contracts with a single private operator who finances, constructs, and operates, at his own risk, all the facilities to supply drinking water On termination of the concession, the system must b e returned to the public authority in perfect condition.This means that during the life 9f the concession the franchise holder must replace worn-out equipment as well as recover the invested capital To realize a return on investment, the concessionaire sel l s the water to the consumers in accordance with the concession contract, which typically allows prices to be charged taking account of inflation, economies of scale, taxation, and other economic factors concessionaire: water quality and source; quantity o f water to be supplied without charge to the public authorities (standposts, sewer flush, fire hydrants, and street cleaning); obligations and terms of connecting up consumers To enable the amortization of the concessionaires investment over a long period, concession contracts are generally for a long term, usually 30 years. Yet because concessionaires are in competition with one another to obtain contracts in various cities, and because the contract might be transferred to another supplier if the concessio n aire does a poor job, the concessionaire has a strong incentive to provide the best and least costly service to the consumer The concession contracts also fix the level of service to be provided by the Electricity generation; transmission, usually over hi g h-voltage wires; and distribution to individual or industrial users On a small scale, all three steps can be handled by the private sector. Small generators can be employed for personal or industrial use. The development of electrical generating capacity a nd distribution in North Yemen is an example of how the market can work in less developed countries. In the mid-20th century, private individuals and families provided for their own needs with small diesel-powered generators and sold excess power to nearb y homes. In 1963, many of the small generators were combined to form an independent company with both government and private shareholders. In 1975, after Yemens civil war, the government took over this and several other electric companies, but still permit t ed private electrical generation by license. Between 1975 and 1981, the proportion of the population with electricity went from.4 percent to 33 percent.The share of electricity provided by the private sector went from 57 percent to 66 percent There are th r ee stages involved in supplying electricity to the public 8 The transmission and distribution of electricity to large numbers of users in a more advanced society poses the problem of economies of scale. Setting up a distribution network of cables, wires, u tility poles, and substations can be so expensive that no more than one supplier can realize a profit in a given geographical region. Thus the state might wish to use a monopoly franchise or perhaps contract out for construction of the electrical grid, us i ng tax dollars and then offer a management contract to a private firm to run and maintain the grid and collect user fees from customers cooperative rather than a state-owned enterprise In this case, consumers purchase their electrical service by joining t h e coop.The management of the coop ultimately is accountable to the owner-members. Thus, better service is provided, the costs kept down, and savings passed on to the users generation of electricity can be handled in part or whole by the private sector as i n cases where the private transmitter or distributor can purchase electrical power on the free market. For instance, industries producing goods for the market can convert heat, generated by the regular production process, into electricity for their own us e or for sale. For example, Orly Anport, which serves Paris, uses this cogeneration to heat its terminals In the 1970s cogeneration produced 18 percent of Italys electrical power, 16 percent of Frances, West Germanys, and 12 percent of the Netherlands.

Pri vate companies generating electricity solely for sale to distributors also can increase the supply and cut the costs. In the U.S Virginia Electric Power Corporation (VEPCO) announced in March 1988 that it was willing to buy all of its future power from su c h private contractors, including power from plants burning wood or coal, plants burning municipal waste, and power produced by industrial cogeneration As a result, VEPCO had offers from suppliers willing to sell 20,000 megawatts, the equivalent of some 20 new large-scale plants with the capacity to bring power to two million homes.

In India, theTata Electric Companies have a long history of generating power for public use. They own generators with a capacity of more than 11,000 megawatts and serve, among o thers, 114 industrial operators Local distribution of electricity also can be handled by a consumer Converting Heat to Electricity. Even with a publicly owned grid, the Telephone Service to make a case for government to provide telephone services. Yet in l ess developed countries, with state-owned phone systems, service is usually extremely poor. It often takes months or years to get a phone installed or repaired. State telephone companies tend to run huge deficits. Therefore, the introduction of market com petition could help improve service and cut costs.

Most telecommunication systems today are centrally controlled as government monopolies; yet phone systems were first developed by the private sector. In 19th century America, service was provided by thousa nds of companies, some large, some small, which adopted common standards Economies of scale and natural monopoly are usually the arguments used 9 voluntarily that enabled a national interconnected network to be formed.

Even today, there are over 1,500 sep arate private telephone companies in the U.S. providing local service, and some 40 companies providing long distance service. Europe has dozens of different telephone networks, all interconnected though almost all publicly owned. Private sector providers a re to be found in the U.S on some of the Caribbean islands, and in a few countries in which telecommunications have recently been privatized, like Malaysia and Britain. Competition, in the sense of consumers being given a choice in telephone service, exis ts only in the U.S. for long distance calls.

Telephones owned by local cooperatives are to be found in Bolivia, Chile and Finland.

In less developed countries, even if the government must provide the capital for construction of a system, management contracts can be put out for bids to the private sector. In Botswana, for example, the government has employed Cable and Wireless PLC, a B ritish firm, to modernize its system and to train its staff. In Argentina and Brazil, the compilation of telephone directories is contracted out to private firms 1 Education Education is not a service with the characteristics of a natural monopoly nor are economies of scale a major problem for teaching. There is no free-rider problem since the service can be charged for. Nor are there negative externalities associated with education. Most governments justify their involvement in education on the grounds th at it is a merit good. Yet if the cost of education is too high, parents, especially those in poor financial condition, will be tempted not to spend money on their childrens education but rather to use available funds to meet immediate family needs.

Furthe rmore, in many poor countries, parents keep their children out of school so that they can be employed in agriculture, vending, or other economic activities to supplement family income provision. In China in the 19th century, for example, people of a neigh b orhood would pool resources to hire a teacher for local children. It is estimated that during that time, in the rural districts of Kwantung province, 50 percent of the men could read ancient times. Private schools, supported by fees and gifts, are widespr ead in the U.S. and are found in many European countries as well.

Parental Choice Through Vouchers. Governments concerned that all people, even the poor, have the opportunity for education can still retain the element of market competition in making the se rvice available. Parents can be issued government vouchers for a .certain sum of money, which they then can spend at the school of their choice to pay for their childrens education.

The school cashes in the vouchers with the government. Even where most or all schools are public, this technique allows parents to reward the best schools Throughout much of history, education has been a matter of private Private tutors have been a means of educating children as far back as 10 1 by enrolling their children in t hem and to punish the less effective schools by avoiding them. If a school is run so poorly that not enough parents send their children, the school will shut down.This gives parents control over the quality of their childrens education and gives teachers a nd school administrators an incentive to do the best job possible. A variant of this system is used currently in Chile, where children go to the primary schools their parents chose, and the government pays the bill Other Public Services There are many ser v ices, often identified as government functions, which can be delivered completely by the private sector. Other services that do require some form of government involvement still can utilize the private sector or market forces. These include Governments co n tracting with the private sector to construct and maintain roads rather than maintaining a government highway department Governments allowing private toll roads, as is done inThailand Private buses providing public transportation. In many less developed c o untries, and even in the U.S extensive informal or illegal private carriers compete with inefficient, subsidized government systems Private health maintenance organizations and competition between health care practitioners to keep down medical care costs L ocal private cooperative banks to provide personal and small business loans Choice for workers of enrolling in private pension plans rather than mandating the government system, as in Chile Delivery of intercity mail, as is done illegally in India CONCLUS I ON Governments, especially in poor, less developed countries, understandably desire to see their peoples living standards raised quickly. In the past, these governments have felt that direct state responsibility for the provision of various goods and serv i ces was the best means to this end. Yet decades of experience, in both developed and developing countries, show that this typically leads to poor quality goods and services, huge financial losses and government debts, corruption of government officials, a n d declining living standards consumer, industrial, and agricultural goods, as well as such services as education, banking, public transportation, and medical care, the private sector is the most efficient and cost-effective means of satisQing popular need s . Competition between suppliers keeps costs low and makes the suppliers more responsive and accountable to public demands. Whenever Keeping Suppliers Accountable. In many cases, such as production of most 11 governments can allow the private sector to pro vide these services, they should do so. But even where the government must have a role in the provision of certain goods and services, the private sector and market mechanisms should be used whenever possible.

The authority to involve the private sector in the provision of public services rests with the governments of the less developed countries themselves. But the U.S. Agency for International Development and such international organizations as the World Bank and Inter-American Development Bank can play a role in such reforms provide information to less developed countries about successful cases of private provision in other countries and how to go about changing from complete state sector provision to partial or complete private provision. In many cases, the governments of less developed countries are not aware that such options are available, much less of how to make use of them. Second AID and other development organizations should not provide funds to government-owned and operated public service provid ers that compete with private providers. The very existence of private providers indicates that the government service is not meeting market demands and that greater private provision would be possible.

Government officials in less developed countries should be imaginative creative, and innovative in searching for ways to carry out such policies.

Contracting out to the private sector for goods and services, offering monopoly franchises for a limited period of time to private suppliers based on competitive bids, issuing vouchers to individuals for purchase of services such as education from the private sector, or forming consumer cooperatives in certain situations are some very effective ways of ensuring that the demands of the public are met Searching for I nnovative Solutions. First, AID and other organizations can Prepared for The Heritage Foundation by Gabriel Roth a Washington, D.C.-based consultant, formerly an economst wth the World Bank's Economic Development Institute This study is based on research in the book The Private Provision of Government Services in Developing Countries by Gabriel Rot4 in the ED1 Series on Economic Development (New York Oxford University Press for the World Bank, 1987 12


Kim Holmes

Acting Senior Vice President, Research