Download Public Sector Costs: Policy

State and Local Public Finance
Professor Yinger
Spring 2016
LECTURE 5
PUBLIC SECTOR COSTS: POLICY
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Class Outline
 Baumol’s Disease
 Evaluating Policies to Promote Productive Efficiency
 The Role of Competition
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Baumol’s Disease
 Today we will discuss ways to promote productive efficiency in the
public sector.
 Before turning to this topic, however, we will gain some perspective on
it by discussing something called “Baumol’s Disease.”
o This is a misnomer—it’s not really such a bad thing!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Baumol’s Assumptions
 In 1967, an economist named Baumol (my micro professor) analyzed a
2-sector economy.
 His model has four key assumptions:
1. One sector has productivity gains, the other does not
2. The labor market is competitive, so the wage in each sector must
equal MRP (also called VMP).
3. Labor is mobile between sectors.
4. The demand for goods in the unproductive sector is inelastic (as
estimated for local governments!)
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Baumol’s Conclusions
 Wages rise with labor productivity in the productive sector
 but also must rise in the unproductive sector because of labor
mobility.
 This leads to some startling conclusions:
o The relative cost of goods in the unproductive sector steadily rises.
o Employment steadily shifts into the unproductive sector.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Mobility Between Sectors
 First, what happens in the labor market when productivity rises
[MRP=(PQ)(MPL)]:
Wage
S1
S
S0
W1
W0
MRP1
MRP
MRP0
L0
L1
Labor
Sector with Productivity Gain
L1 L0
Labor
Sector without Productivity Gain
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Responses to Price Increases
 Second, consider what happens in product markets when labor costs
rise:
MC1
$
MC
1
P
0
P
MC
$
1
1
P
0
P
Dema0
nd
0
Demand
Q1 Q0
Q
Sector with Productivity Gain
MC
S1 S0
S
Sector without Productivity Gain
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Net Impacts in Labor Markets
Third, go back to labor markets to consider price increases MRP=(PQ)(MPL)]:
S1
Wage
S1
S0
W1
W0
MRP0
L0 L2
MRP2
MRP1
MRP1
L1
L1 L0 L2
Labor
Labor
Sector with Productivity Gain
Sector without Productivity Gain
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Leviathan?
Spending and employment in state and local government have been
steadily rising for decades.
Some commentators say this is evidence of leviathan—of increasing
inefficiency by bureaucrats.
Their policy prescription is to boost accountability programs and
privatization.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Interpreting Baumol’s Disease
 But a more likely explanation is that these trends reflect “Baumol’s
Disease,”
o Which is nothing more than an inter-sector shift as productivity
gains make a society richer.
 In this view, the cost of the public sector does increase over time, but
this trend just preserves levels of local public services—and we can
afford it!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Other Examples of Baumol’s Disease
 Baumol’s disease does not apply only to public services.
 Several scholars have applied it to the arts:
o Technology cannot replace the actors in one of Shakespeare’s plays.
 A recent column in the New York Times applied it to higher education:
o Mankiw, “Three Reasons for those Hefty College Bills”
http://www.nytimes.com/2015/12/20/upshot/three-reasons-for-those-hefty-collegetuition-bills.html?hpw&rref=upshot&action=click&pgtype=Homepage&module=wellregion&region=bottom-well&WT.nav=bottom-well&_r=0
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Boosting Productive Efficiency
 Regardless of the role played by “Baumol’s Disease,” productive
efficiency is a good thing.
 So how can public officials lower costs and hence cut taxes (or raise
service quality without raising costs)?
 The answer:
o Observe
o Experiment
o Evaluate!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Step 1: Use Your Judgment
Formal evaluation of programs or management reforms are usually not
available.
Thus, it is appropriate for you (when you become public officials!) to
use your own judgment:
o to select programs and reforms that appear to have worked in
other places;
o to design new programs and reforms.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Step 2: Use Evaluation Studies and Principles
But evaluation should always be in the back of your mind.
o Search for evaluations of the programs or reforms you are
interested in.
o Make an honest judgment about the quality of existing
evaluations.
o Informally apply basic evaluation principles to programs and
reforms you are considering.
o Implement formal evaluations whenever possible!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
The With-Without Principle
 What is the basic problem facing someone wanting to evaluate any
public program?
oWhat you want is to know how one place differs with and without
the program.
oWhat you observe is either (a) what the world is like after and
before the program or (b) what one place is like with the program
and another is without it.
oThus, you cannot be sure that the effects you observe are not due
to non-program differences over time or across places.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Approaches to Program Evaluation
 The two ways to solve this problem are:
o random assignment
o statistical control
 Random assignment insures that differences across time and place are
not correlated with program.
 Statistical controls can account for observable (and some
unobservable!) differences across place or time.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Random Assignment
 Random assignment is the preferred method in most cases.
oIt provides results that are intuitively compelling and scientifically sound.
oIf you believe in cutting costs, become an advocate for evaluation using
random assignment!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Random Assignment Examples
 Random assignment has been used to study (among other things):
o Welfare-to-work programs
o Unemployment insurance
o Job training
o Income maintenance
o Housing assistance
o Electricity pricing
o Education (e.g. Charter Schools)
o Early childhood development
o Criminal justice policy
o Child health and nutrition
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Statistical Studies
 Random assignment is not always feasible.
 The best statistical studies:
o Must have extensive data to ensure that differences aren’t due to
unobservable factors.
o Must have comparable treatment and control groups based on
observable factors, which often requires new “matching”
methods.
o May have multiple observations over time so they can “difference
out” unobservable factors.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Competition and Costs
 You all learned in micro-economics how private prices are driven down
by competition.
 With some important qualifications, the same lesson applies in the
public sector.
 Three issues are particularly important.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Provision vs. Production
Issue 1: The distinction between provision and production
 Each unit of government is legally obligated to provide certain
services, i.e. to ensure that these services are available.
 In many cases, however, the unit of government responsible for
provision does not actually have to produce the service itself.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Production Examples
 Production Arrangements Include:
o Contracting out to a private firm
o Contracting out to another government agency
o Outsourcing, i.e. purchasing from a private company
o Use of vouchers to finance private production
o Intergovernmental cooperation (to gain economies of scale)
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Competition vs. Privatization
Issue 2: The Distinction Between Competition and Privatization
 Competition generates incentives to cut costs so as to maintain
business, funding, or reputation.
 Privatization substitutes private incentives (profit) for public
incentives (public service).
 They do not necessarily go together.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Alternatives to Public Delivery by One Agency
Consider the following ways to move away from delivery by a single
public agency:
Public
Private
Monopoly
Public Agency
Private Electric
Company
No-bid Contract
Competition
Charter Schools
Public School
Vouchers
Private School
Vouchers
Bids & Contract
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
The Benefits and Costs of Privatization
 Although competition is likely to cut costs, the impact of privatization on
costs is not so clear:
o Private firms are probably more likely to innovate because it boosts
their profits.
o But private firms are also more likely to cut corners or to neglect
social concerns—if their contract allows—in order to boost profits.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Defining Performance
Issue 3: The Need for a Clear Definition of Performance
 The key to harnessing competition and private firms’ desire for profits
is to write a contract that:
o Specifies performance standards
o Provides clear incentives to meet those standards
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
The Requirements for Successful Privatization
 Contracting out to private firms can work well if:
o The relevant market is competitive and bidding is possible
o The performance objectives can be clearly specified in the contract
o A firm’s performance can be monitored
o Financial rewards and/or penalties can be written into the contract,
too.
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
Documenting Cost Savings
Big Problem Number 1:
 Cost savings are almost impossible to document.
 Cost savings only exist when full costs are lower, holding performance
constant.
o But many costs are hidden.
o And performance usually cannot be measured.
 Beware of cost-savings claims!
State and Local Public Finance
Lecture 5: Public Sector Costs: Policy
The Role of Politics
Big Problem Number 2:
 Contracting to private firms often yields political benefits (i.e.,
campaign contributions from the firms in the industry) even when it
does not boost efficiency.
 In the case of services with well-funded lobbying activities and/or
voiceless beneficiaries, contracting is likely to go too far.
 Be careful with this tool!