January 23, 2003

Chapter 18

Other Forms of Privatization

In chapter 17 we distinguished between complete privatization, or liquidation, and incomplete privatization. There are various forms of incomplete privatization. In this chapter we consider three forms. In the first two, the government still retains responsibility for causing the good or service to be supplied yet does not use a bureau to supply it. In the first case, the budget office makes contracts with private firms to supply the good or service. We call this contracting out. In the second, the budget office subsidizes qualified demanders by issuing them vouchers to buy. The demanders use the vouchers to buy the goods or services from suppliers. The suppliers then redeem the vouchers by exchanging them with the government budget office for a specified sum of money. We call this a voucher system. In addition to these cases, we discuss the removal of monopoly protections that had, for one reason or another, previously been given to firms. This is privatization in the sense that the government gives up responsibility for helping to determine how private individuals and firms can employ their resources.

1. CONTRACTING OUT

     Contracting out occurs when the government decides to quit hiring and managing resources yet it wants to continue causing the service to be supplied. It achieves this by purchasing the service from a private company according to the terms of a contract. Instead of hiring the workers, buying the equipment, etc., it hires a private company, or several companies. For example, trash collection may have previously been carried out by the "City Refuse Department," which is a bureau that bought trucks and dump sites, hired employees, and so on. Contracting out means liquidating this activity and buying trash collecting services from one or more private trash collecting companies. For another example, consider a government department of transportation that, at first, is responsible for repairing roads. A legislature may decide to contract out their work because it has discovered that the cost per mile repaired is lower in some other country or jurisdiction that uses a private contractor.

     Complete privatization involves one step: liquidating the bureau that has been supplying the service. Contracting out involves two steps: liquidating the bureau plus finding a private contractor to supply the service according to specifications.

Competitive Contracting

     In many of the newer democracies, the government buys services under contract but there is no, or little, competition. The contract is given to members of the chief executive's political party, to his friends or family, or to the firm that pays the highest bribe. This kind of contracting is simply a means of granting special privilege to particular individuals. When we write about contracting out in this chapter, we are referring to a situation in which the suppliers are chosen impartially according to a competitive process. We call this competitive contracting. In competitive contracting, the budget department of the government describes in detail the service that it wants supplied. Then it asks local suppliers to bid for the contract. A contractor bids by announcing the price she will charge the budget department. To avoid the prospect that the bidders will find out about each others' bids -- and, consequently, collude instead of compete -- the budget office in such situations must make the bidding secret by requiring firms to submit sealed bids. The government assures each bidder that the sealed envelopes containing the bids will be opened and inspected at the same time and that the lowest bid will be accepted.

     Citizens in countries with a tradition of central control are often surprised to find that telephone, telegraph, radio and television transmission, water supply, sewage removal, electricity, and gas are sometimes provided in other countries by private companies. They do not realize that private provision is often more economical. Consider the case of fire protection. At first glance, fire protection may seem to fit into a class of services that could only be supplied effectively by a government bureau. Yet a private fire protection industry has developed in the state of Arizona. Private companies enter into contracts with the smaller cities to provide them with the service. They also offer their services to private individuals whose jurisdictions do not offer fire protection. Comparative studies indicate that the private companies provide fire protection for about half the cost of public fire departments serving similar communities. Further, the private companies - tiny though they are - have been the cutting edge of scientific progress in the fire protection industry. They have invented an entirely new technology which, given the small funds they have for research, is a remarkable achievement. This example suggests that when private companies know that local governments are receptive to private contracting, they have an incentive to seek out the governments as customers and to develop technologies that are most suitable to supplying them.

     In some cases, the service demanded by the government through contract cannot be precisely specified. We shall consider such cases later in this part. For the moment, however, we want to identify some general principles that apply to all cases. So we assume that it is easy to exactly specify the service that is demanded. We begin by studying the possibility of price fixing among competitors.

Price Fixing

     Price fixing refers to a market situation in which otherwise competing sellers join together to fix the price they charge for a good in order to constrain the buyer's choice. For example, we can imagine that the only sellers of salt at a local farmer's market would have a meeting and agree to charge the same price. Price fixing in a pure market economy is a type of collusive monopoly.(See Chapter Three)

     In the case of services paid for by government contract, price fixing refers to acts by suppliers that are intended to assure that a particular firm is the winner of the government contract and that the firm is paid a higher price than if the collusion did not occur. Losing firms agree to submit bids that are much less attractive than otherwise or they choose not to submit bids at all.

Price Fixing in Government Contracts vs. Market Price Fixing

     Fixing the price of a government contract is quite different from fixing the price in a market economy. In a market economy, a buyer has a personal incentive to discover whether she is being tricked by colluding suppliers. If she believes she is being tricked, she can either threaten not to buy at all or she can try to break up the group by offering a secret deal to one of the colluders. In democratic government contracting, it is difficult to make and enforce the rules necessary to give a government buying agent a comparable incentive.

Rewarding Suppliers Who Lose the Bid

     Ordinarily, the firms that agree either to lose the bid or to drop out of the bidding must be rewarded for their restraint. They may be given direct money payments or other concessions. For example, the winner may agree to award lucrative subcontracts to the losers. Alternatively, the winner may agree not to compete for future contracts of the same kind or in markets where competition would otherwise be keen. Another possibility is that the competitors may agree to swap shares of stock at market prices that exist before the bidding.

Price Fixing as a Means of Redistribution

     The first step in understanding the effects of price fixing is to realize that it causes the price to be higher than otherwise. The losers are the taxpayers; the winners are the price-fixing firms. Money that might otherwise be spent by taxpayers is transferred to the price-fixing contractors. Thus there is a redistribution of wealth from taxpayers to suppliers. From the taxpayers' point of view, they are cheated.

Resource Wastes due to Price Fixing

     The second step is to recognize the wastes entailed in a price fixing scheme. There are two kinds of wastes. The first is collective decision-making costs facing the price-fixers. To plan a price-fixing agreement, the firms must meet, make a collective decision, and enforce it. The second are the concealment costs. Assuming that price fixing is illegal, the price fixers must try to conceal their activities. Even if the government agents allow the price fixing, it must be concealed from voters. The resources employed in these activities are wasted in the sense that if price-fixing were not possible, they would probably be used to help produce goods for consumption. This loss is similar to the investment loss in rent-seeking.(See Chapter Seventeen.)

Deterring Price Fixing

To avoid undesir-able redistributions (cheating) and potential inefficiency in government contracting, a legislature should pass laws threatening severe penalties to firms convicted of the practice. Of course, the penalties must be backed up by sufficient enforcement and prosecution of suspects. In spite of the fact that price fixing is relatively easy and inexpensive to deter, it frequently occurs in a democracy. We can explain this in two ways. First, it is possible that the legislators or bureaucrats who are responsible for administering the competitive bidding, are lazy or dull. They may not be aware of the potential for it. Second, the legislators, bureaucrats, and law enforcement officials may receive bribes or other favors not to reveal that it occurs. The latter is possible only when the activities of the agency administering the contracting is secretive. To avoid price fixing in both of these cases, members of a collective should require the agency to make public all of its activities. This can be achieved by means of a provision in a constitution.

Losses from Price Fixing vs. Losses from Bureau Supply

     It is not uncommon for writers in the field of public administration to favor bureau supply over contracting out because they believe that if the government opens the supply to competitive bidding, the result will be price fixing. As we have seen, there are ways to deter price fixing. However, even if there is price fixing, the logic suggests that contracting out is superior, from an efficiency point of view, to bureaucratic supply. In this part, we use a simple price fixing model to demonstrate this. Although both are inefficient, when compared with the norm of the market supply of a private good, bureaucratic supply may be more wasteful. The reason can be traced to the incentives of the managers. We can demonstrate this point by referring to a simple model.

                                            Figure 18-1

 

           PRICE FIXING VS. BUREAUCRATIC SUPPLY

     In the model of the budget-maximizing bureau chief in Chapter 14, we saw that it is possible that the consumers' surplus would be completely wasted away by bureaucratic oversupply. Consider figure 18-1, which is a modification of figure 14-2. We saw in the simple Niskanen model that the bureau chief aims for a budget of cfk0. In this case, there is a bureaucratic waste of efg to offset the consumers' surplus of aec. All of the potential consumers' surplus is lost. The reason is that resources that would otherwise be used to produce other goods in the economy are used by the bureau chief to produce additional goods that are valued less than their marginal costs.

     We can use the same diagram to represent price fixing. The goal of price fixers is to get a contract to supply the quantity q for a sum of money equal to aeq0. They aim to make a profit of aec. Like the bureau chief, they have no interest in allowing consumers to gain. Unlike the bureau chief, however, they do not want to waste resources. They merely want to transfer the consumers’ surplus to themselves. Thus, in the graph, the same area, aec, is labeled "potential consumers' surplus" and "price fixers' profit."

     In the case of a price-fixing contract, if price fixers achieve their goal of maximizing the potential profit, the budget would be higher than it needs to be and consumers would not gain at all from the supply. However, except for the price-fixers' costs of collective decision making and costs incurred to conceal the price fixing from the government, at least the resources would not be wasted.

     It is wise when using the simple Niskanen model of the bureau for comparison to recall from Chapter Fourteen that there are a number of possible mitigating circumstances that may make the model unrealistic. Nevertheless, the overall tendency for bureaus to grow to inefficiently large sizes suggests that the bureaus may be more wasteful than contracting, even if there is price fixing.

Gangsterism

     Competition on contracts to supply services to the government is often blocked by the illegal use of force. Criminal gangs may coerce potential competitors to either not bid or to inflate their bids. Such activities are most common in new democracies. In some of these, gangsters operate with impunity because they either run the government or have bribed government agents. In these, citizens are not yet accustomed to voting the politicians who permit this activity out of office. In others, either politicians do not have sufficient control over the police or the police do not possess sufficient firepower to subdue the criminal gangs.

     The aim of gangsterism is to force suppliers who would otherwise compete in the satisfaction of consumers’ wants to charge a monopoly price and then to compel the suppliers to turn over their monopoly profit to the gangsters. The result is very much like price fixing except that additional resources are wasted in the gangsters’ efforts to seize the profits and in the victims’ attempts to avoid this. The waste is especially large if there are competing gangs, since competition is likely to entail violence. Yet gangsterism may save resources also, as compared with ordinary price fixing. Because of the coercive power of gangsters, they can more easily force firms to abide by their price fixing agreement. This is often a problem for private companies.

     It is quite possible in some cases that in the absence of privatization, the politicians and bureaucrats who control the supply of some service would have acted more in the consumers’ interests than the gangsters who replace them. Privatization may fail to reduce inefficiency not for economic reasons but because (a) the former bureaucrats may not have been as inefficient as the Niskanan model suggests and (b) gangsterism may entail high transactions costs. Until a nation develops the legal rights required to have a competitive market economy, privatization may not be a good substitute for bureaucratic supply.

Monitoring the Supply

     To determine whether the terms of a contract are met requires monitoring. The goods or services that are delivered or provided must be inspected. In the case of services, random, spot inspections are necessary. Probably the most important thing one can say about monitoring is that laws should not hinder the monitoring process. Ordinarily, any private citizen or media reporter who wants to learn about whether a contracted good or service is being provided according to contract should be permitted to find out.

A Complaint Bureau

     Citizens must be given an opportunity to report their findings. This opportunity can be provided by a complaint bureau. In everyday life, government complaint bureaus, like other bureaus, often conduct their activities in secret. It should be evident that in order to be most effective, such a bureau should be required to publicize the complaints it receives, to investigate some percentage of them, and to publicly present the results.

Periodic Inspections

     In the case of durable material goods like a bridge, it may be necessary to periodically inspect the construction before it is completed, since some parts of the finished product will be concealed from view. It may also be necessary to hire experts to make such inspections. The inspection reports should also be presented to the public. And care should be taken to monitor the interaction between the inspectors and the contractors, since contractors may have an incentive to pay off inspectors in exchange for issuing false reports.

Rewards for Whistle-Blowing

     Another mechanism that might be considered is a reward for "whistle-blowing" by employees of the contractor. It is very difficult for a company to cheat the government without getting help from its employees. If the government offers a high reward to an employee who reports such cheating, it can reduce the amount of it. It would be logical for the size of such a reward to be determined in an independent court on the basis of estimated gains to taxpayers.

Contracts in Which the Service Cannot be Fully Specified

     In many cases, it is possible for the legislature or the bureau that is buying a good or service to fully specify the exact service that the government demands. An example is the government's purchase of certain office supplies, like standard white paper and staples. In such cases, the most efficient way to purchase the service is to have competitive bidding. The government should make an announcement to the media of what it intends to buy. Then it should accept bids from competing companies. In order to minimize the prospect for collusion among bidders, the government should require competing bids, pass a special law imposing high penalties for companies caught conspiring to fix the price of a government contract, strictly enforce the laws, and require complete openness. High penalties for power abuse and strict enforcement should also apply to the government agents who administer the contracts and even to those who enforce them and judge whether there have been violations.

     In other cases, the exact service cannot be fully specified. The bureau that is charged with buying the service must be given discretion to contract for a good or service in a way that he surmises will satisfy the demands of legislature. There should still be competitive bidding. However, it is much more difficult for the typical voter to tell whether the legislature or bureau has made the best deal. Examples are contracts to develop new weapons systems and research contracts. The most important rules for this kind of contract are (1) that, except for some aspects of national defense, communication between the agent and the companies should be open to public and media inspection and (2) that incentives to inflate prices and take bribes should be made as small as possible.

Allocation of Uncertainty

     A contract specifies the nature of the service to be provided, time of delivery, and payment conditions. Most importantly, it specifies the penalty or compensation if the conditions of a contract are not met. This last part determines how the uncertainty-bearing will be allocated. Suppose that a contract is made to build a bridge. The contract specifies that a bridge of a given type is to be finished by January 1, 2010. If the bridge is not completed, the penalty or compensation clause tells how much money the contractor must pay to the buyer. If the penalty is large enough to compensate the buyer for his reliance on the finished bridge, the producer must bear all of the uncertainty about the completion date. If there is no penalty, then the buyer must bear all this uncertainty. If the penalty is small, the uncertainty is shared.

Who Should Bear Uncertainty for Government Contracts?

     As a general rule, the uncertainty about the completion of contracts between democratic government agents and private contractors should be borne by the contractors. The reason is the weak connection between voter-taxpayers and the agents. It is costly for citizens to take the appropriate actions to minimize or otherwise deal with the uncertainty. Suppose, for example, that the bureau of transportation makes a contract with a company to build a bridge. The contract specifies a date of completion but it assigns no penalty for non-completion. It contains a clause that directs the contractor to make an "earnest effort" to complete the construction by the due date. Suppose that the bridge is not completed on time and there is reason to believe that the corporation did not make an earnest effort. Then the government can sue in the courts that determine whether contracts have been violated. However, in such a suit, the government must prove to the court that the corporation did not make an earnest effort. We can contrast this kind of contract with a second one which specifies that, except under extraordinary circumstances, if the bridge is not completed by the due date, the builder must pay a penalty of, say, 1 million dollars a day until it is completed.

     Under the first contract, it would be practically impossible for citizens to determine whether the agents should bring such a suit and, if they did, whether they were using government funds wisely in the court case. Under the second contract, however, such a determination would be a simpler matter. The only uncertainty that would exist is about whether extraordinary circumstances were present. Since the burden of proof of such circumstances would be on the builder, the government agent would presumably have to take a much less active part in any judicial dispute than he would have to take if their was a dispute regarding the first contract. Other things equal, the price that a bridge contractor would bid for a contract in which she must bear the uncertainty

is likely to be greater. However, the increase in price is likely to be small in comparison with the efficiency savings.

     This general rule seems to apply to all cases except national defense and research.

Research Contracts

     Consider research contracts. A company that is hired to do basic research cannot specify the outcome in advance. Such services require special treatment. One way to make the company bear the uncertainty is to demand that it make a promise regarding the value of the research. The company is paid the full contract amount only if the value of the research is judged to equal or exceed the value promised. This can be determined by a reputable private arbitrator, by a politically independent commission, or perhaps by an appointee of an independent judiciary. This procedure may not be useful for research on a new weapon or weapons system, since secrecy is essential in these cases. However, in other cases of research, such as in medicine, it may be useful.

2. THE VOUCHER SYSTEM

The voucher system refers a government subsidy that is given to demanders in the form of vouchers, or tickets, to buy privately-supplied services. The vouchers are issued by a government agency, say the budget bureau. After the demanders use the vouchers, the budget bureau reimburses the private suppliers at a predetermined rate. It is as if the vouchers are special government money that the government promises sellers to convert into real money. Vouchers are sometimes used to subsidize poor families. For example, the budget bureau might give the head of household of a poor family one hundred dollars in food vouchers each month. He takes the vouchers to the supermarket where he buys one hundred dollars worth of food. Then the supermarket transfers the $100 in vouchers to the budget bureau. In return, the bureau gives the supermarket $100 in cash.

     The budget bureau could give cash to the poor family. The difference is that the vouchers must be used to buy the specific goods or services specified on the voucher. For example, a supermarket can only accept the vouchers for food purchases. It cannot accept them for say, liquor, appliances, or toys. Of course, the law can be broken. A supermarket clerk, for example, can allow a voucher holder to buy $90 worth of liquor if he pays $100 in vouchers. The clerk can then use the extra $10 in vouchers to buy food for himself or he can resell. Because of the potential for fraud, voucher exchanges must be monitored and defrauders threatened with punishment. Enforcement of a voucher plan is costly.

     To help us understand the voucher system, let us take the example of a voucher system for education. Under this program, if the legislature was currently supplying education services through hired bureaucrats in public schools, it would arrange to stop doing so. In other words, it would liquidate the public schools. In its place, it would give vouchers to parents, which they could use to purchase education services. The services would be supplied by existing private schools and new ones that entrepreneurs would form in anticipation of profits.

     The first step in setting up a voucher system for education is to appoint an education commission to define the types of education service that parents will be allowed to purchase with vouchers. The commission might decide, for example, to only subsidize education services that meet certain standards regarding the minimum qualifications of teachers and a minimum number of hours spent studying such subjects as language, science, math, and history. It may rule out schools that teach racism, religious extremism, intolerance, how to commit crimes, pop music, or how to start a revolution. Once it decided upon minimum qualifications, it would allow parents to purchase education from anyone who wanted to go into the business of supplying approved school services. This includes private tutors, one-room schoolhouses, non-profit corporations, corporations for profit, and parents themselves. All would have a right to compete in the education market. Parents would be free to choose among the qualifying educational programs.

     When the parent of an eligible student enrolled the student in a certified education program, she would give the teacher or principal of the school the voucher that had been issued to her by the education commission. The teacher or principal would later exchange the voucher for money.

     Consider how such a system would effect the principal of a typical private school. Suppose that the average cost of a year of ninth-grade private education is $10,000. Then each year, the government would give parents of ninth-grade children a voucher to buy $10,000 worth of approved education. If the parent chooses school A, as opposed to B, she would give A's principal the voucher. The principal could exchange the voucher for money.

     The most important benefit of a voucher system is due to competition. Given that the government sets the voucher price, schools would compete in quality. Those schools that produced the highest quality of education in the eyes of parents who value quality would be selected to receive the vouchers. Other things equal, a school that provided low-quality service from the parents' viewpoints would quickly go bankrupt, as the parents shifted to other schools. A school that provided what parents regard as high quality service for the same voucher price could afford to expand. Also important is the strong profit incentive for school managers to minimize costs. Managers would permit neither overcrowding nor excess capacity, since these would reduce its profits compared with what is possible. Competition among schools would insure that if a school became too inefficient, other things equal, it would go out of business. And freedom of entry would insure that if an outsider developed a new idea about how to improve the quality or reduce the cost of education, she would have an incentive to try to capitalize on it by introducing it into the market. In short, to the extent that parents could judge education quality, competition would improve both quality and efficiency.

     By using the voucher system, the government can also shift some of the monitoring tasks to the parents. Each parent has a greater incentive to monitor under the voucher system because she knows that if she discovers poor quality, she can gain by shifting her child to another school. Efficiency in supplying service would not have to be monitored by the government since, under price competition, the more efficient schools, other things equal, would offer lower prices.

     A voucher system would not eliminate the need for government monitoring. The government would still need a commission to certify that a school receiving voucher money is meeting certain minimum requirements. And it would have to monitor voucher exchanges and threaten defrauders with punishment. But the system would substantially reduce the government’s monitoring.

     A partial substitute for a voucher system is a system of tax exemptions for parents who send their children to certified private schools. Another example of cases where the voucher system might be employed is in healthcare. A voucher system is a substitute for medical care supplied by government-employed doctors and government hospitals.

Resistance to the Voucher System and Ways to Reduce It

     Attempts to introduce the voucher system in education have encountered very strong resistance in the U.S. The main resistance has come from unions and organizations representing public school teachers and other public school employees. This is not surprising since such people would lose their guarantees of government funding. On the other hand, those employees who are capable of contributing to the efficient supply of education services that parents demand could easily find employment and business opportunities in the private sector after the voucher plan was adopted. Indeed, unless the method of providing education changed away from using so many teachers, administrators, and auxiliaries; the most competent would do better. It is possible, however, that the method would indeed change.

     It is difficult to predict the effect of a wholesale shift to a voucher system. One reason is that we do not know today which kind of education supply technology offers the most efficient and attractive service. The existing system in most places is to provide education by means of classrooms with teachers and textbooks. This is a very old system. In recent years, many educators have argued that television technology has rendered the traditional classroom method of teaching obsolete for many students. With the recent development of interactive computer and internet technology, an even more advanced media has emerged. Given these developments, it is possible that a properly administered voucher system would drastically reduce the demand for traditional school teachers and administrators. Perhaps it is their vague realization of this possibility that underlies much of the resistance to change.

     One way to reduce resistance is to compensate the existing administrators and teachers. We discussed some possible ways of doing this in Chapter Seventeen. Another possibility is to allow existing administrators and teachers at a government school to buy their school's assets at discount prices in order to start a private school.

We can learn an important lesson from considering a voucher system for causing services to be supplied. We assume that it is reasonable to want to subsidize education and other services. Although these are not pure public goods, they may confer substantial external benefits that are joint and nonexcludable. However, a collective has a choice of methods. It can supply these services itself or it can subsidize the market supply. In the case of education, most collectives have decided on government supply. But we know from our study of bureaucracy that government supply is likely to be very inefficient. Moreover, the bureaucrats who supply the service have an incentive to pressure politicians to continue the bureaucracy regardless of its inefficiency. Thus, these agencies may persist long beyond the optimal time for shutting them down. Moreover, if they can, politicians will try to employ the agencies to try to help them get reelected or to help their political party. A better plan may be to subsidize the market demand by means of a voucher system.

Pressure to Control Voucher Conditions

In thinking about the voucher system, it is wise to remember that it is a government program. The education commission, or some government agency, is a bureau whose actions are subject to the same kind of potential inefficiency, political pressure and rent seeking as other bureaus. Parents, administrators of schools, teachers, and other suppliers of education services may pressure politicians and the education commission to make decisions in their interest rather than in the interest of the people who receive the external benefit from a more highly educated populace. This can easily stifle competition in quality. For example, even under the voucher system, an education commission may interfere with market competition by requiring such things as minimum teacher salaries or other benefits, maximum student-teacher ratios, the use of a particular technology or the exclusion of other technology, and so on. It should be evident that true competition cannot prevail when schools are not permitted to operate freely in markets. When we consider these possibilities, we are led to make a recommendation. Although the education commission should be allowed to determine standards of results, or output, it should not be allowed under normal circumstances to determine the methods that suppliers use to supply that output. A school that fails to meet the education commission output standards should be disqualified from participating in the voucher program. But a school that uses unorthodox methods (or inputs) for educating students who meet the standards should not be.An education commission should not be permitted to use any policy that has the effect of restricting competition, except under extraordinary circumstances.

3. BREAKING UP GOVERNMENT-SPONSORED

MONOPOLIES

     Many democratic governments have established monopoly bureaus. For example, in some countries, it is a crime for non-bureaus to deliver first class mail, to offer telephone service, to open a new school, to operate a private bus company, to sell cable TV subscriptions, to start a new airline, to import and sell sugar, or to sell gasoline. Instead of criminalizing competition, a government may give such large subsidies to the government bureaus or it may subject private competitors to such stringent regulations that individuals and companies find it unprofitable to compete.

     Most of the newer democracies have inherited monopolies from the previous dictatorial regime. Usually these make substantial losses and should be liquidated. In some cases, however, the monopolies seem capable of continuing to make profit. The services they supply are not pure public goods because it is possible to charge a price and to exclude non-payers. Otherwise, the monopoly bureaus could not earn a profit.

It is possible that the government bureau is supplying goods for which no market failure is present. Such a bureau is highly unlikely to be able to succeed in competition with private business unless it is given some kind of special treatment. Often governments protect such bureaus by outlawing private supply. In circumstances of this sort, the bureau should be liquidated following the procedures described in Chapter Seventeen. It would be more efficient to privatize and to substitute a general tax, such as a general sales or income tax, for the profit income, if there is any. This would enable the government to avoid two kinds of losses. The first is the efficiency loss associated with the higher monopoly price. (See Chapter Sixteen) The second is the loss in production efficiency due to the bureaucratic nature of the government-operated firm. Government bureau chiefs cannot earn profit and their ability to reward and punish lower level bureaucrats is constrained by government regulations. So the bureau chiefs and lower-level bureaucrats are seldom efficient in the market sense.

     In addition to these are, there are three other possible sources of resource waste due to rent-seeking, or pressure group, activity. First there is pressure from representatives of particular classes of resources suppliers. One the one hand, the employees, through an association like a public employees union, may demand high pay or fringe benefits. We have seen that legislators may give in to pressure for fringe benefits because voters do not recognize or are not concerned about deferred payments. On the other hand representatives of classes that claim to have been previously disadvantaged may demand that the monopoly not operate according to profit maximizing principles but according to "principles of justice." Examples are calls to hire a quota of minority or handicapped workers. Second, there may be pressure from consumers in general for lower prices. Being rationally ignorant of revenues and costs, they may pressure legislators to dictate a lower price. Often they are not successful because of the high collective decision-making costs they face. However, when they are successful, the result is either a shortage and rationing, since the “law of supply and demand” can not be countermanded by legislation, or government subsidies to encourage supply. Such subsidies must, of course, be paid out of higher taxes or reduced government activity elsewhere. Third one class of buyers may be able to pressure legislators to force bureaus to adopt pricing policies that benefit them at the expense of another class of buyers. For example, residents of depressed areas may pressure legislators to require a government monopoly supplier of gasoline to sell to them at below-cost prices. The loss would be compensated by higher prices to other consumers. In economics, such a pricing policy is called cross subsidization. Cross subsidization means using revenue from classes of buyers for whom price is greater than cost to subsidize classes of buyers for whom price is less than cost. By following this policy, a bureau can create a class of voters who would vehemently oppose any plan that threatens their service. This may make it difficult politically to introduce competition, since competition would force the firm to stop the unprofitable service.

     If monopoly causes inefficiency, why does the ruling party not replace it with a general tax? There are several possible explanations. First, if the monopoly is actually earning a profit, retaining it may be a way for the strong ruling party to conceal its revenue raising from public view. If voters do not realize that their loss due to the monopoly price is higher than it would be if they paid a sales or income tax, a ruling party that changed the system would lose support at the polls. If it raised the sales or income tax, some taxpayers would shift to the opposition party. If it reduced spending, some recipients of services and government employees would shift. Second, the monopoly may be an important source of rewards for supporters and party loyalists. It may provide them with jobs, valuable services, or other favors that the ruling party finds too costly to give directly. Third, the party may just not realize that the burden on citizens of raising funds via the monopoly supply of the service is greater than the burden of raising funds via general taxation.

The Case of Public Utilities

     So-called public utilities like electricity, natural gas, water, and sewage may be special cases. Under modern technology, the service may be cheaper to produce if one firm produces for all demanders. Economists refer to such cases by the term natural monopoly. If a natural monopoly was free to charge whatever price it wanted, it would charge a high price that would discourage low-demand consumers from buying, even though they are willing to pay a price that is higher than the additional cost of servicing them. It would cause an efficiency loss. The economics of natural monopoly was discussed in Chapter Three.

     The typical government response to a situation of natural monopoly is either to supply the service itself by means of a bureaucracy or to regulate the profit and service of a private monopolist. We have already shown that bureaucratic supply is likely to be inefficient. So let us focus on regulation of a private monopolist. We shall see that this is another case of government failure.

Inefficiency of Regulated Monopoly

     To understand why regulated monopoly is also inefficient, we must put ourselves in the shoes of the monopolist and the regulators. Starting with the monopolist, we begin by noting that public utility monopolies are almost always corporations. This means that stockholders share any profit that the firm makes. To see how regulation affects the relationship between stockholders and the corporation’s manager, recall that in the unregulated market economy, if a corporation is free to charge whatever price it wants, the amount of profit would depend mainly on whether the hired manager correctly chooses the profit-maximizing price and whether he produces the product at the lowest possible cost. If the stockholders believe that the manager is incompetent or untrustworthy, they would fire him. Or, if they do not find out about his incompetence or untrustworthiness, perhaps because of the free rider problem, the price of shares would fall (see Chapter Fourteen). The corporation would then be a takeover target for someone who would fire the manager. The threat of being fired gives the hired manager of a monopoly corporation an incentive to charge the profit-maximizing price and to be cost efficient.

Regulation changes matters. To see how, we shift our perspective to the regulators. If the regulators single-mindedly pursued the goal of efficiency, they would try to force the monopolist to reduce price and to provide quality service without incurring unnecessary costs or interfering in other ways with the firm’s service to consumers. This goal is typically called price regulation. However, efforts by a government bureau to regulate according to this goal are not likely to succeed. There are two reasons: (1) weakness of the monitoring incentive and (2) asymmetric information. The monitoring incentive is weak because the monitoring task must be performed by a government bureau. The bureau chief who is charged with the task of regulation is similar to other bureau chiefs in her desire to expand at the expense of efficiency in regulating the public utility. Unless the chief believes that closely monitoring the regulated monopolist will help expand her bureau, she is likely to sacrifice efficiency in monitoring in order to pursue other bureau-expanding activities or to enjoy other personal benefits. Asymmetric information is due the fact that the corporation manager is in the best position to know his costs. Even if the bureau chief were motivated to monitor efficiently, she lacks information about the monopolist’s costs. The bureau chief can demand accurate information. However, because she cannot easily judge the information she is given, the regulator can manipulate it.

     The asymmetric information problem makes it very difficult for voters, and even politicians, to know whether a particular price is too high. So regulating monopoly by regulating its price is not a very useful goal. Recognizing this, voters, legislators and bureaucrats usually shift to a secondary goal -- profit regulation. The reason that if price is too high, then it will lead to profit that is too high. By not permitting high profit, they can control a monopoly’s propensity to charge a monopoly price. This seems reasonable at first glance. Corporate profits must, under the law, be reported accurately; so if a natural monopolist bureaus happens to earn a high profit, the regulatory bureau can order the corporation to reduce its price until profits return to what the bureau regards as an acceptable level. Ideally, the regulatory agent would decide the price on the basis of estimates of future corporation profit. Her aim would be to enable the corporation to earn a profit, but not a profit that is too high. Thus instead of pursuing the goal of price regulation, regulators of natural monopoly ordinarily try to regulate profit. They try to assure that the corporation only earns a "normal,” or average, profit. This goal is called profit regulation.

     Let us now put ourselves in the shoes of the manager of a natural monopoly whose profit is regulated in this way. Such a manager faces a situation where the corporation’s profit will remain more or less the same regardless of what he does. If he causes costs to fall, say by making a technological advance that substantially reduces costs, the regulating bureau is likely to revise its estimate of future profit upward. To prevent the higher profit, the bureau would force the monopolist to reduce price. On the other hand, suppose that the manager inflates his costs. Within limits, the regulating bureau is likely to revise its estimate of future profit downward, thereby allowing the manager to charge a higher product price than otherwise. Under these conditions, the manager has virtually no control over long-term profit. Because of this, stockholders have little reason to be concerned about a manager's competence or trustworthiness. No matter what the manager does, within limits, the corporation will still earn a normal profit. Since profit can neither rise nor fall due to the manager’s actions, stockholders tend to leave the manager relatively free to pursue his own ends. Thus the manager is freed from the ordinary corporate constraints on his revenue-earning and cost-minimizing activities.

     If the manager of a public utility is not constrained by stockholders, what will he do? One possibility is that he will persuade stockholders to raise his salary and other perquisites. Since these are merely costs and since the regulator would allow the costs to be passed on to consumers in the form of higher prices, the stockholders have nothing to lose. In addition, the manager might be able to pay inflated resource prices to supply companies that he or his parent corporation partly owns or that pay him kickbacks.

     One way for the regulating agent of the natural monopoly to reduce the problem of inflated resource prices is to bar a company that supplies a regulated service from engaging in other lines of business, to which it might be able to shift its profits. However, because of the information asymmetry, only a part of the manager's deliberate inflation of costs can be controlled.

     The personal goals of the manager of the natural monopoly may be less oriented toward obtaining money or favors. He may use the income from the bureau for humanitarian purposes to finance services that promote the nation’s development, that help the poor, or that help preserve the environment. Of course, whether his idea of a humanitarian contribution matches that of other people must always be problematic. Others may believe that there are better ways to achieve humanitarian goals than those that are chosen by the manager of a regulated natural monopoly (if, indeed, a manager has such goals).

Regulation to Promote Technological Progress?

     Perhaps the most important drawback of public utility regulation is that the manager of a regulated monopoly firm lacks incentives to improve technology. As mentioned above, if he successfully improves technology, the regulators will not allow the firm to earn profit. And if he fails to improve technology, he need not worry about losing out to technology-conscious competitors, since he is protected from competition.

     Recognizing this, some "public utility economists" have recommended that a government regulator should adjust her regulatory policies to promote technological advance. They say that the regulatory bureau should allow the firm to earn some amount of additional profit from a technological advance. Such economists often fail to realize two important characteristics of the regulatory environment: the asymmetry of information and the nature of the political pressure. Regarding the first, the firm has expertise about technology and costs that the regulatory bureau lacks. Thus, it is difficult for the regulatory bureau to tell how much a firm's profit is due to technological advance. Regarding the second, the regulatory bureau is subject to pressure from pressure groups, the chief executive and legislators. Having discretion to decide on the amount of profit the public utility can earn and the price it can charge exposes the bureau to pressure from the utility itself, from pressure groups, and from other special interests. Under these conditions, it seems unrealistic to expect a regulatory bureau chief to make decisions solely on the basis of the sum of the benefits.

Allowing Competition

     One way to improve matters that is often overlooked is to allow competition under the same regulated terms that the monopolist faces. Suppose that the regulated natural monopoly is operating efficiently. Then a would-be competitor would be foolish to try to compete, since she is unlikely to survive competition from an already established firm. On the other hand if the regulated monopoly is very inefficient, the competitor could drive the existing monopoly out of business by charging a lower price. Afterwards, the regulatory bureau may force the new monopoly into a position like the old one. However, during the transition, consumers would benefit from the lower price. Moreover, the new monopoly would know that if it became too inefficient, it would be challenged by another competitor.

     A second, and perhaps more important benefit from allowing competition is the prospect for technological advance. An outsider may be able to identify a new technology that would reduce price. If he has a prospect for short term monopoly profit and long term stable profit, he would have an incentive to identify and implement a new technology.

Is It Really a Monopoly?

     In fact, the regulated firm may not be a natural monopoly. If a business, say the telephone business, is truly a natural monopoly, allowing competition cannot make matters worse. If the business is not a natural monopoly, the situation is very different. In this case, a number of competitors will be able to offer a lower price or better quality service. Regulation is unnecessary.

     It seems that there is no sensible reason, on efficiency grounds, to restrict competition with a regulated monopoly. And there are good reasons to allow it. Even if we were absolutely certain that a particular industry was a natural monopoly at the time when legislators decided to regulate, changes in technology may have altered the situation. The only way to find out is to permit competition.

     It is sometimes difficult politically to permit competition after it has been restricted for many years. There are two reasons: (1) employees of the monopolist do not want to lose their jobs and (2) the firm is likely to have engaged in cross subsidization. We have already suggested ways to deal with these obstacles.

Promoting Competition after Paying Setup Costs

     In some cases, competition may be possible once the set up costs are incurred. An example is media services to the home via cable. Cables are now capable of carrying a very large quantity of signals and of separating those signals according to supplier and function. A government may contract to have the cable laid and connected to each household. Then it could allocate different portions of the cable to a number of different suppliers, just as it allocates rights to use radio and TV frequencies.

     A different example is electricity, which requires electrical wires to be connected to each consumer's residence. The government could set up an electricity clearinghouse in which it would receive electricity generated by private companies and send it out to the residences. The private companies would compete against each other for contracts with individual consumers. After promising to supply a household with electricity, a company would then be responsible for supplying the clearinghouse with the amount of electrical power that its customers use. The same kind of arrangement might be made for natural gas and pipe-supplied water.

     It is sometimes possible to develop a good substitute for the government-as-clearing house approach. It is to require the regulated monopoly that supplies a service at a given price to buy the same service at that same price from other suppliers. For example, if you buy a windmill and, as a result, generate more electricity than you need; such a policy would allow you to sell the extra electricity to the local electric company at the same price the company would charge if you had to buy your electricity from it.

The Temporary Monopoly Franchise

     We should be careful to distinguish between the natural monopoly and situations of nonexclusive benefits. A firm may be reluctant to incur high set up costs because it cannot exclude a future competitor from using resources that it causes to be produced during the set up process. For example, an electric company in a developing country may need to clear public land in order to string its cables. Assuming that the land remained public, an identical competitor could then lay additional cables on the already cleared land and supply electricity at a lower total cost than the initial firm. A prospect of this sort may make a company hesitant to make the initial outlay and could delay the supply of electricity to a community. In cases like these, a temporary monopoly franchise may be the best way to provide an incentive for the first company to enter the business. A monopoly franchise gives a single firm the exclusive right to supply some service. In the case of a monopoly franchise we would not want to regulate that first monopoly's profit, since monopoly profit is the reward for making the investment in set up costs.

     It is important that the monopoly franchise be temporary, however. At a later time, we would want to remove all restrictions on competition.

Questions for Chapter 18

1.    Define competitive contracting, price-fixing, voucher, price regulation of a natural monopoly.

2.    Describe contracting out and give an example that is different from the text.

3.    Describe the difference, from the viewpoint of consumers, between price-fixing on government contracts and price-fixing in the market.

4.    Suppose that suppliers agree to fix the price on a government contract and to allow a particular supplier to win the contract. Tell how the winner can reward the losers?

5.    The text says that price-fixing on government contracts entails waste. Describe the sources of this waste.

6.    If price fixing on government contracts is so easy to deter, why does it occur?

7.    Compare the inefficiency of the Niskanen bureau with the inefficiency due to contracting out, even though there is price fixing. It may be useful to present a graph. If you do, be sure to explain the graph in words.

8.    How is gangsterism possible in the new democracies?

9.    What is the aim of gangsterism in dealing with government contracts?

10.  There is a serious problem monitoring the supply of government services through contract. According to the text, what methods are available to deal with this problem.

11.  In some government contracts, the service demanded cannot be fully specified. The provisions are subject to negotiation between the government purchasing agent and the supplier. Under these circumstances, which policies will best help assure that the contracts are met?

12.  Explain why it is wise to require a contractor who builds a bridge or road to pay a high penalty if the job is not completed by the time that is promised.

13.  According to the text, why should the supplier bear all of the uncertainty about the completion date in the case of large, durable products like bridges?

14.  Explain how research contracts differ from other contracts to supply government services.

15.  How can legislators make a company that supplies research under contract bear all of the uncertainty that the benefits of the research to voters-consumers will exceed the costs.

16.  Give an example of a voucher system that is different from the one in the text. Be sure to tell how the voucher system works from the point of view of government administrators, the recipients and the supplier of services.

17.  According to the text, the voucher system as a means for a government to cause services to be supplied may improve both the quality of services provided and the efficiency with which they are provided. What is the main reason for this improvement. Explain by giving an example.

18.  Who monitors the supply of services under the voucher system?

19.  Consider a good whose consumption confers substantial external benefits from which the beneficiaries cannot be excluded. Assume that private companies have always supplied this good. If the government wants to increase the supply it could (1) provide the good itself by creating bureaus, (2) subsidize the private companies to produce more, (3) subsidize demanders. Which is most desirable? Explain your answer. (This is an essay question. Your answer should come not only from what you have learned in this chapter but also from what you have learned in other chapters.

20.  Consider a government-sponsored monopoly that is supplying a good for which no market failure is present. Describe the inefficiencies that can be eliminated by breaking up the monopoly.

21.  Describe cross-subsidization and explain how a government monopoly's adoption of a cross-subsidization policy can delay a political decision to allow private firms to compete with the monopoly.

22.  Suppose that a government blocks competition and establishes a monopoly in some good in order to obtain the profit revenue to help finance other government services. Explain why, even though a tax is a more efficient way to raise money, the government does not replace the monopoly with the tax.

23.  Explain why the government regulator of a monopoly cannot effectively achieve the goal of price regulation.

24.  Does the manager of a profit-regulated corporation have an incentive to be efficient? Explain.

25.  Suppose that a particular service is a natural monopoly. The government decides to allow a private company to supply the service and to regulate its profit. So it sets up a regulatory commission. Should the regulator allow the monopoly to also engage in other lines of business? Why? Why not?

26.  Suppose that members of the collective in the past believed that a particular industry was a natural monopoly (e.g., electricity, water, or telephone). So they voted for politicians who promised to regulate a single private firm that supplied the service. After the regulated monopoly has been supplying the good for a few years, should members of the collective support a law that protects the monopoly from competition by private firms? Explain.

27.  Should a regulated natural monopoly be protected from competition by the government? Explain.

28.  If a government bureau or a previous natural monopoly is suddenly opened to new competition from private companies, some consumers of a cross-subsidized service and some employees may lose. Thus they are likely to oppose a law that permits competition. Can you think of a way to overcome this political opposition?

29.  Tell the difference between a natural monopoly and the temporary monopoly franchise.

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J. Patrick Gunning
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Feng Chia University
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Taiwan, R.O.C.
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