Report Title

Draft

10:52 PM

Center for Policy Excellence: budget policy

Workshop ten

The role of government: government failure

(Based on Policy Analysis Weimer and Vining)

Seminar notes for fellows

Prepared by Diana Cook

February 1999

Contents

11.Introduction

2.Problems inherent in direct democracy22.1The paradox of voting22.2Preference intensity and bundling22.3Democracy as a check on power43.Problems inherent in representative government53.1Rent seeking: diffuse and concentrated interests53.2Problems of the district based legislature83.3Limited time horizons: electoral cycles93.4Public agendas, sunk costs and precedent93.5Representatives and analysts104.Problems inherent on bureaucratic supply114.1Agency problems114.2Bureaucratic failure as market failure134.3Analysts and bureaucracies145.Problems inherent in decentralization155.1The implementation problem155.2Fiscal externalities165.3Analysts in decentralized political systems166.Summary of government failure177.Solutions to government failure187.1Freeing markets187.2Simulating markets197.3Contracting out197.4Transitional assistance198.Homework20

1. Introduction

Sometimes free markets do not produce efficient outcomes. As we saw in the course notes for workshops eight and nine, these situations are called market failures. The invisible hand is even less able to ensure that economic prosperity is distributed fairly. A goal of many public policies is to achieve a more equitable distribution of economic well being.

Sometimes government may be able to correct the deficiencies of the market. However, government intervention also has deficiencies. Therefore, public policy must be informed not just by an understanding of market failure but of government failure. Even governments blessed with the most intelligent, honest and dedicated public officials can not be expected to promote the social good in all circumstances.

As policy analysts we should exercise caution in advocating public intervention into private affairs. Some market failures are simply too costly to correct; some distributional goals are too costly to achieve. More fundamentally, we do not know just how government intervention will work out. The theory of government failure is not yet as comprehensive and powerful as the theory of market failure. While it raises important warnings about the general problems likely to be encountered in pursuing social values through public policies, the theory of government failure is not well developed enough to allow us to always predict the consequences of specific government interventions. Therefore, unintended consequences often arise.

The following discussion classifies government failure as problems inherent in four general features of political systems:

Direct democracy.

Representative government.

Bureaucratic supply.

Decentralized government.

2. Problems inherent in direct democracy

In democracies voting serves as the mechanism for combining the preferences of individuals into social choice or social decisions.

If voting were a perfect mechanism for aggregating individual preferences then the job of the policy analyst would be much easier. Questions about the appropriate levels of public goods provision, redistribution and public regulation of private activity could be answered directly through referenda. The vast number of issues arising in a large industrial country, however, make reliance on referenda impractical for all but the most important issues. Even if improvements in communications technology greatly reduce the logistical costs of voting, the time and other costs citizens face in learning about issues limit the attractiveness of direct referenda. But reliance on referenda for the revelation of social values suffers from a more fundamental problem: no method of voting is both fair and consistent.

2.1 The paradox of voting

Any voting system that satisfies a basic set of fairness conditions may produce illogical results. This is known as the paradox of voting. Under four key conditions, Arrows General Impossibility Theorem states that any fair rule of choice will fail to produce a consistent social ordering of policy alternatives. Social choices will change depending on the order of the agenda. Therefore, those who can control the agenda will have great opportunity for manipulating social choice.

2.2 Preference intensity and bundling

2.2.1 Preference intensity

Definition:

Tyranny of the majority: where either a permanent majority consistently inflicts costs on a minority or a temporary majority opportunistically inflicts very high costs on a temporary minority.

Imagine a society that decides every public policy question by referendum. If everyone votes according to his or her true preferences on each issue, social choices may result that are both inefficient and distributionally inequitable.

For example, consider a proposal to build an express highway through a populated area. If we were able to elicit truthful answers from each person about how much he or she would value the road, we might find that a majority of people would each be willing to pay a small amount to have the road built. However, a minority, perhaps those living along the proposed route, may require a large amount of compensation to be made as well off after the construction of the road as before. If the total amount the majority would be willing to pay falls short of the total amount needed to compensate the minority, then the project is not Pareto efficient or even potentially Pareto efficient (see box). Further, most would think the project inequitable because it concentrates costs on a minority. Nevertheless, the project could be adopted in a majority rule referendum if all voted their true preferences.

Pareto efficiency

In course notes eight and nine we discovered that in most cases the market would produce the most efficient outcome. One way to assess a government intervention is the concept of Pareto efficiency. In the absence of market failure, prices would allocate goods and services so that it would be impossible to find a reallocation that would make at least one person better off without making at least one person worse off.

Economists refer to such a distribution as being Pareto efficient. It is a concept with great intuitive appeal: shouldnt we be dissatisfied with an existing distribution if we can find an alternative that will make one person better off without making someone else worse off?

In some circumstances, market failure means that government intervention can potentially enhance the market outcome. Even if an intervention is not Pareto efficient, it may be potentially Pareto efficient. That is, those who are better off are able, in theory, to compensate those who are worse off. This implies an increase in social surplus. Note that potential Pareto efficiency does not necessarily mean that the compensation takes place. Therefore, there can still be significant distributiuonal impacts from potentially Pareto efficient policies.

Of course, not everyone in the majority will necessarily vote according to strict private interests. Some may vote against the project out of a sense of fairness. Others may fear setting a precedent that might be used to justify unfair policies while they are in the minority. However, in the absence of these constraints, direct democracy can lead to tyranny of the majority. That is, where either a permanent majority consistently inflicts costs on a minority or a temporary majority opportunistically inflicts very high costs on a temporary minority.

Majorities can inflict high costs on minorities because voting schemes do not allow people to express the intensity of their preferences. No matter how much one person dislikes a proposed project, he or she only gets one vote. Even if the majority wants to take the interests of the minority into consideration, they have no guarantee that the minority will be truthful in revealing the intensity of their preferences. In fact, the minority would have an incentive to overstate the intensity of their dislikes, perhaps checked only by the need to maintain some level of credibility. This contrasts with private markets where people can express the intensity of their preferences by their willingness to purchase various quantities at various prices.

2.2.2 Bundling

An alternative approach to ruling by referendum, is for candidate decision makers to stand for office on platforms consisting of positions on important policy issues. Voters would have to evaluate the bundle of positions offered by each candidate. Different voters may vote for the same candidate for different reasons. In fact, a candidate holding the minority position on every important issue may still win the election.

For example, one-third of the electorate may vote for a candidate because of her position on trade policy, which they believe to be the most important, even if they dislike her positions on all the other issues. Another one-third may dislike her position on trade policy but vote for her because of her position on defense spending. Thus, she may win the election even though the majority of voters oppose her position on all issues including trade and defense policies.

The general implication for democracy is that whenever people must vote on a bundle of policies, it is not necessarily the case that any particular policy in the winning bundle represents the will of a majority. Even a landslide victory may not represent a mandate from the people for the winners proposed policies.

2.3 Democracy as a check on power

These problems show that democratic processes will not always give us a true assessment of social values. But despite these problems democracy offers several advantages:

The opportunity for participation encourages citizens to learn about public affairs. Actual participation may make citizens more willing to accept social choices that they opposed because they had an opportunity to be heard and to vote.

It provides a check on the abuse of power by giving the electorate the opportunity to overturn onerous policies and remove unpopular decision makers. Democracy may not always led to good, let alone the best, policies, but it provides an opportunity to correct the worst mistakes.

Discussion:

Why can we not rely on democratic processes to lead to policies where benefits are greater than costs?

Tyranny of the majority: can not express intensity of preferences.

Bundling of policies.

3. Problems inherent in representative government

In modern democracies, representatives of the electorate make and execute public policy. In most democratic systems voters chose representatives to legislative or executive, and sometimes judicial, branches.

The legislative (Parliament) typically plays a dominant role in establishing public policy by passing laws but also often plays an administrative role by monitoring budgets and overseeing government operations.

Members of the executive branch make public policy when they interpret legislation, as, for example, when agency heads issue rules under broadly delegated authority to regulate some aspect of commerce. In addition, they may make proposals that influence the legislative agenda.

Representatives often face the dilemma of choosing between actions that advance their conception of a good society and actions that reflect the preferences of their constituencies. Two factors greatly influence the way representatives actually behave:

Representatives have their own private interests. Elected representatives usually seek either reelection or election to higher office. Candidates often behave as if they are trying to maximize the percentage of votes they will receive. This strategy requires them to pay more attention to the interests of the most responsive citizens than to those who are unlikely to vote or who are likely to vote according to party, ethnicity or other general considerations. In general, the personal interests of representatives tend to push them towards responsiveness to their constituencies and away from concern for broader social welfare.

Individuals must incur costs to monitor the behavior of their representatives. Given financial and time constraints, individuals will usually not find it in their private interests to articulate policy preferences or to monitor closely the actions of their representatives. Those who do monitor tend to have strong policy preferences based on ideology or financial interests. Therefore, representatives tend to be more closely monitored by interest groups which have preferences very different from the broader constituencies.

Analysts can sometimes get representatives to adopt policies on the basis of principle. More generally, however, analysts find allies among representatives whose private interests happen to lead them to what analysts believe are good policies.

3.1 Rent seeking: diffuse and concentrated interests

Definitions:

Rent: payments to owners of resources above those that the resources could command in any alternative use.

Rent-seeking: Lobbying for government interventions that will create rents.

In a world where most people pay little attention to their representatives, the politically active few have an opportunity to wield influence disproportionate to their number.

Private self-interest often plays an important role in motivating public participation. The greater the expected net benefits one expects to reap from some political activity, the more likely that one will undertake the activity. Policies that would spread large aggregate benefits widely and uniformly among the electorate may not elicit active political support because, for any individual, the costs of political activity exceed the expected benefits. Similarly, no individual will find it in their interests to protest policies that spread costs widely. In contrast, at least some people will find it in their own self-interests to become politically active when policies have concentrated costs and benefits. Therefore, policies can be biased towards those with concentrated benefits and away from policies with concentrated costs. This bias opens the door for the adoption of policies for which total costs exceed total benefits.

Concentrated economic benefits (and diffuse economic costs) often arise when governments intervene in markets. The interventions generally create economic benefits in the form of rents payments to owners of resources above those that the resources could command in any alternative use. Lobbying for such interventions is called rent seeking.

Discussion:

Examples of situations of rent and rent seeking in Ukraine?

3.1.1 Types of rent seeking

The effort to use government to restrict competition is perhaps the oldest form of rent seeking. Examples include:

Securing a legal restriction on competition such as monopoly rights. Bribery by those seeking local monopolies has contributed to the corruption of local public officials in many countries. Example in Ukraine? Professions often attempt to keep wages high by restricting entry through government-sanctioned licensing. If the restricted entry does not provide offsetting benefits, such as reductions in information asymmetry (see course notes eight and nine), the professionals gain rents at the expense of the consumers. Example in Ukraine? Domestic manufacturers often lobby for tariffs and quotas on foreign imports so that they can sell their product at higher prices. If they succeed, domestic manufacturers extract rents from domestic consumers. Examples? Firms within an industry may also seek regulation as a way of limiting competition if firms believe they will be able to meet the regulations more easily than their competitors. In addition, industries may lobby and capture the regulators.

Sometimes governments generate rents for producers by directly setting prices in markets. For example, many countries set price floors on some agricultural products. Examples in Ukraine?Note that programs like price supports often produce only temporary rent transfers. If farmers believe that the government will permanently guarantee a price above the market clearing level, the price of land will rise to reflect the higher value of its output. Specifically, the price of land will reflect the present value of future rents. A farmer who sells his land after introduction of the price supports therefore captures all the rent. The new owner, who must service the debt on the purchased amount, does not realize any profits above the normal rate of return. Therefore, attempts to regain efficiency and reduce government expenditures through elimination of price supports will force many of the current owners into bankruptcy.

Discussion:

This is an important issue for Ukraine. How could we deal with it?

Even the initial beneficiaries of the market intervention may fail to realize the full rents because of the costs of rent seeking activity. Direct lobbying and campaign contributions can be costly. In the extreme, all the rents may be dissipated, leaving the rent seekers no better off than they were in the absence of the intervention.

3.1.2 When diffuse interests prevail

Despite the advantages concentrated interests enjoy in mobilizing for political activity, they do not always prevail over diffuse interests. If those with similar interests are already organized, then they may be able to use the existing organizational structure to overcome the free-riding problem (see course notes for workshop eight and nine) that would keep them from expressing their interests individually.

However, even without the advantage of prior organization, diffuse interest can sometimes overcome highly concentrated interests. Two factors tend to facilitate the success of diffuse interests:

Attention to the policy issue from a large segment of the electorate.

Low public trust in the concentrated interests.

Mobilization of diffuse interests that simply impede the rent seeking of concentrated interests probably advance the social good. Sometimes, however, they facilitate rent seeking.

For example, rapidly rising rental prices often attract widespread attention in communities with low rates of home ownership and generate animosity towards landlords who appear to be profiting at the expense of tenants. Policy makers may respond with rent control programs that provide modest short run savings to current tenants at the expense of landlords.

Discussion:

Will this help efficiency or equity? Can you show on chart?

However, price ceilings generally reduce economic efficiency and rarely led to greater equity. This is shown in Figure 1. The price ceiling is Pc. It is below the unrestrained market price of Pe. At price Pc, consumers demand Qd but producers supply only Qs. In the best case, consumers gain a surplus equal to the rectangle PePcBC. This corresponds to the producers loss of rents on the Qs units they sell. However, the social cost of the transfer is a deadweight loss of social surplus from reduced consumption equal to the triangle ABD.

Figure 1 Surplus transfers and deadweight losses under price ceilings

In the worst case, consumers dissipate the surplus they gain from producers as well as the surplus equal to the area of the rectangle PxPeCD. When supply is limited to Qs, consumers value the last unit available at Px. Therefore, consumers will be willing to pay up to Px Pc in nonmonetary costs such as queuing, searching and perhaps even bribing to obtain shares of the limited supply. These costs have the effect of dissipating the benefits consumers enjoy from the lower monetary cost.

In order to achieve the best case an efficient rationing scheme is needed. However, these can be administratively costly.

Advocates of price ceilings usually defend their positions on equity grounds. They argue that the poor have a better chance at obtaining a fair share of the good if allocation is not done solely on the basis of price. But the mechanisms of nonprice allocation do not always favor the poor. For example, queuing involves less hardship for two-adult families with flexible professional work hours than for single parents working fixed hours. More importantly, price ceilings tend to create a number of big losers. For example, those families who are unable to get a rent controlled apartment. Because the identities of the big losers are generally not revealed until after the implementation of price ceilings, their interests rarely receive consideration at the time of adoption.

Rent seeking can have adverse effects on economic growth by shifting resources towards lobbying and away from production. In addition, attempts by people and organizations to protect their rents reduces the capacity of society to adopt new technologies and reallocate resources to meet changing conditions.

3.2 Problems of the district based legislature

In most countries, legislators represent geographically defined districts. While they may wish to do what is in the best interests of the entire country, their self-interest in terms of reelection encourages them to pay special attention to the interests of their districts. This often leads to policy choices that do not contribute to aggregate national welfare.

The problem goes beyond legislators emphasizing the social benefits that accrue to their own constituencies in deciding how to vote. Certain social costs sometimes appear as benefits to districts. For example, a benefit cost analysis of a weapons system from the social perspective would count expenditures on components as costs. A politician, however, might very well count expenditures on components manufactured in her own district as benefits because they contribute to the vitality of the local economy.

District-oriented valuation of expenditures often leads to adoption of policies with net social costs as legislators bargain with each other to get their share. This process, sometimes called logrolling, involves assembling a collection of projects that provide sufficient locally perceived benefits to gain adoption of the package as a whole. When coupled with unwillingness on the part of representatives to bear the political costs of raising taxes, logrolling contributes to deficit spending.

Discussion:

Examples in Ukraine? Policies adopted with high regional benefits but negative national benefit/cost ratio.

3.3 Limited time horizons: electoral cycles

Representatives must often make decisions that will have consequences extending many years into the future. From the perspective of economic efficiency, the representative should select policies for which the present value of benefits exceeds the present value of costs. However, self-interest operating in an environment of imperfect monitoring creates incentives for representatives to place more emphasis on costs and benefits that will occur in the short run.

If a representative has to stand for reelection he faces the problem of convincing the electorate that his actions have contributed to their well being. It will be easier for him to claim credit for effects that have actually occurred than for ones expected to occur in the future. Therefore, he may be able to enhance his chance of reelection by supporting projects with high short-term benefits even if the longer-term costs mean the net social benefit of the project is negative.

This is most likely to occur if the representative feels vulnerable about his reelection. The more threatened he feels, the more likely he is to select projects with immediate and visible benefits for which he can claim credit. Another factor is the ease with which an opponent can draw the attention of the electorate to the yet unrealized future costs.

Discussion:

Is this a problem in Ukraine? Can you think of examples where government adopted policies with short-term benefits but long-term costs?

Solutions?

Help government develop and communicate strategy: require governments to explain short-term policies in the context of long term strategy.

Stress long term consequences of decisions in policy advice.

MP: independent central banks to deal with this problem.

Fiscal accounts for more than 3 years. Balance sheet.

3.4 Public agendas

When media draw public attention to some undesirable social condition, representatives may be able to share the limelight by proposing changes in public policy. These attempts to convert undesirable and highly visible conditions to public policy problems help to determine the policy agenda. Representatives and analysts who prefer specific policies may have to wait for an appropriate condition to arise to gain a policy window into the agenda.

A policy agenda strongly influenced by the pattern of media coverage is not necessarily consistent with the concept of public policy as a rational search for ways to improve social welfare. The policy agenda only reflects appropriate priorities if the media happen to cover conditions in proportion to their worthiness as public policy problems.

A media driven policy agenda discourages the careful evaluation of alternatives. Representatives who take the lead in proposing policy responses are most likely to benefit from the wave of media coverage. Further, adoption of any policy response may hasten the decline in media coverage by giving the appearance that something has been done about the problem. Consequently, more comprehensive and better analyzed policy responses may not have time to surface.

3.5 Sunk costs

The previous positions of politicians will also often constrain their current options. For example, economists and politicians often view sunk costs differently. To economists, resources committed to a project in the past and are no longer available for other uses are sunk and irrelevant when deciding whether to continue or terminate the project. However, the politician who advocated the project initially may be loath to terminate it for fear that opponents will point to abandonment as an admission of a mistake.

Examples?

3.6 Precedents

Precedents often provide opportunities for representatives to gain favorable public reaction to their proposals. By pointing to apparent similar policies adopted in the past, representatives can appeal to peoples sense of fairness: We gave a loan guarantee to firm X last year, isnt it only fair that we do the same for firms Y and Z now? Without close examination, it may not be clear that the circumstances that made the guarantee to firm X good policy do not hold for firms Y and Z. Policy analysts should anticipate the possibility that any new policies they recommend may serve as precedents for actions in the future. A subsidy, waiver, or other action that, when considered in isolation, appears socially desirable, may not actually be so if it increases the likelihood that representatives will inappropriately adopt similar actions in the future.

3.7 Representatives and analysts

The political system does not generally base public policy on the careful weighing of social costs and social benefits.

Discussion: What can analysts do?

To the extent that this failure either results from, or is facilitated by, limited information, policy analysts may be able to contribute to better social choices by providing assessments of the likely consequences of proposed policies.

To the extent that inattention to social costs and benefits is tied to the self-interest of representatives, analysts may be able to contribute to the social good by helping to craft politically feasible alternatives that are better than those that would otherwise be adopted.

In any event, analysts should try to anticipate the limitations of representative government when they propose and evaluate public policies.

4. Problems inherent In bureaucratic supply

Governments often create publicly funded organizations to deal with perceived market failures. Some of these agencies provide public goods, others regulate natural monopolies, externalities and information asymmetries. Like private firms, they use labor and other inputs to produce outputs. Unlike private firms, however, they need not pass a market test to survive. Consequently, the extent to which their continued existence contributes to aggregate social welfare depends greatly upon the diligence and motivations of the representatives who determine their budgets and oversee their operations. The very nature of public agencies, however, makes monitoring difficult and inefficiency likely.

4.1 Agency problems

As we discussed in the course notes for workshop eight and nine, the principal-agent problem arises because employers and employees do not have exactly the same interests and because it is costly for employers to monitor the behavior of their employees. As agents have more information about their own activities than their principals, agents can pursue their own interests to some extent.

Public executives generally operate in environments characterized by great asymmetry of information, not just with respect to the general public but with respect to other representatives as well. For example, the manager of a public organization is in a much better position to know the minimum cost of producing any given level of output than either the public or their representatives who determine the organizations budget.

Discussion:

Do public sector managers have an incentive to produce output at least cost?

Therefore, agents have an incentive to maximize the difference between the budget the organization receives and the minimum cost of producing the output. Managers of these organizations enjoy the greatest freedom when this difference is large and unknown to the representatives. It would be economically efficient for managers to produce the output at minimum cost and return the difference to the government. However, this would reveal information about the minimum cost - information that could be used when deciding how much to allocate to the agency in next years budget. The observation that public agencies rarely fail to spend their budgets, sometimes exhorting employees to spend faster as the end of the fiscal year approaches, suggests that few executives view relevation of their true costs as an attractive management strategy.

If the agency were a private firm with sales revenue as the source of their budget, then the owner would simply keep the difference between sales and costs as profits. Public sector managers not wishing to return any profits, have an incentive to find personally beneficial ways to use this money to make their jobs as managers easier. For example, with extra personnel managers can tolerate some shirking by employees that would be time consuming and perhaps unpleasant for the manager to eliminate. Increased spending on such things as travel and supplies may contribute to morale and thereby make managing more pleasant.

Agency loss is inherent in all organizations, whether private or public. But three factors make it a more serious problem in the public sector:

The difficulty of valuing public outputs.

Lack of competition.

Inflexibility of civil service systems.

4.1.1 Difficulty of valuing outputs

In the absence of market failure, the marginal social value of the output of a competitive firm is equal to the market price. Customers reveal this value by their willingness to pay. However, most public agencies do not sell their output competitively. Therefore, representatives face the problem of having to impute values to such goods as national security, law and order, and health and safety. Even when representatives are sincerely interested in estimating the true social benefits of such goods, analysts can rarely provide convincing methods for doing so.

The absence of reliable benefit measures makes it difficult to determine the optimal size of public agencies. Often distributional goals further complicate the valuation problem. Private firms generally need not be concerned about which particular people purchase their products. In contrast, public agencies are often expected to distribute their output in accordance with equity principles.

4.1.2 Effects of limited competition on efficiency

Competition forces private firms to produce output at minimum cost. Firms that do not use resources in the most efficient manner are eventually driven from the market by firms that do. Because public agencies do not face direct competition, they can survive even when they operate inefficiently.

Public agencies also face inappropriate incentives for innovation.

Discussion: Why does the public sector have less incentive to innovate?

Usually public agencies have weaker incentives to innovate than private firms. The profit motive provides a strong incentive for firms to find new production methods that will cut costs. When one firm in an industry successfully innovates, others must follow or eventually be driven from the industry. Additionally, firms may be able to capture some of the industry-wide benefits of their innovations through patents. In comparison, public agencies are generally neither driven from existence if they do not innovate nor capturable of fully capturing the external benefits if they do.

Some incentives to innovate exist:

Agency heads may seek prestige or career advancement from being seen as an innovator.

Budgetary retrenchment may encourage cost-reducing innovations as agency heads try to maintain output levels to clients.

However, these incentives do not operate as consistently as the profit motive and threats to firms survival. In fact, public agency heads who wish to innovate face several disadvantages relative to their private sector counterparts:

They have no competitors to imitate. While they can look to organizations with similar functions, they face the valuation problem in deciding whether a new technology has created net benefits elsewhere.

They can not borrow money from banks to cover start-up costs. They have to seek money from government who are often unwilling to allocate money to uncertain research and development projects.

Civil service rules may make it difficult to secure specialized expertise needed to implement innovations.

4.1.3 Inflexibility caused by civil service protections

Apart from high-ranking officials, the majority of public servants are employed independently of political parties. This provides continuation in expertise when ruling parties change and insulation against attempts to use agencies for partisan purposes. However, the same rules that make it difficult to fire people for political purposes, make it difficult to weed out the unproductive and incompetent. Fixed pay schedules tend to underreward the most productive and overreward the least productive. As the former leave for higher paying jobs in the private sector, the public organizations are left with a higher proportion of the latter.

As it is difficult to fire people, great care must be taken in hiring. However, this reduces the ability of managers to implement new programs quickly. This can often led to managers simply using a less qualified person who is already in the civil service system. The more often decisions are made for expediency, the more difficult it is for the civil service to be efficient in the long run.

Also shielding monopoly public agencies from political interference can make than unresponsive to consumers. Elected representatives have an incentive to be responsive to their constituent consumers. But the separation of politics and administration limits the role politicians can play in informing agencies about public wants.

4.2 Bureaucratic failure as market failure

Bureaucratic failure often manifests itself as public good and externality problems.

4.2.1 Organization public goods and common resources

A public good is one that is nonrivalrous or excludable. All organizations must confront public good problems. However, the rules imposed on public agencies to compensate for lack of competition, can exacerbate these problems.

For example, consider the organizational common property resource of a central stock of equipment and supplies. If employees have unlimited access to the stock, then we would expect over consumption. In response, private organizations usually institute internal transfer prices so that employees see prices close to the cost. But for such a system to work as more than an upper limit on total spending, employees must be able to use funds save in one category for some other purpose. In public organizations, however, profit sharing is usually prohibited and strict line-item budgets often prevent the moving of funds across categories that make relative prices meaningful. Consequently, we generally expect allocations of such resources as travel funds and computer time to be fully expended and often misallocated because ex ante controls prevent the establishment of effective internal transfer prices.

4.2.2 Organizational externalities

Production externalities arise when organizations do not see the full social marginal costs and benefits of their actions. Several factors make public agencies especially prone to negative externalities:

They often have the legal right to use resources without paying their full marginal cost. For example, the compliance costs that tax agencies impose on businesses and individuals. This causes a tendency to impose excessive compliance costs rather than measures that would shift some of the cost to the public agency.

Public organizations are often exempt by law from torts by those who have suffered damages. Thus, legal responsibility for large externalities can be avoided.

4.3 Analysts and bureaucracies

Policy analysts who do not anticipate the problems inherent in bureaucratic supply risk giving bad advice about policy alternatives. The risk arises in considering fundamental issues like the scope of government and also in more instrumental issues like the choices of organizational forms for providing public goods.

In addition, analysts who work in bureaucratic settings must be careful to get their personal and organizational interests in perspective when called upon to give advice about the public good. At the same time, an understanding of the incentives others face in their organizational settings is often essential for designing policy alternatives that can be adopted and successfully implemented.

Discussion:

If evaluating alternatives to solve a market failure by creation of a new government agency, what aspects of government failure should you consider?

Lack of incentive to produce output at least cost: agency problems, lack of competition.

Problems in determining how much to produce and how to distribute.

Incentives created by organizational structure.

5. Problems inherent in decentralization

Many democratic countries have highly decentralized systems of government. Some powers are exercised by the central government, while others are reserved for the governments of local jurisdictions. Within these various levels of governments, agency executives often enjoy considerable discretion over policy and administration.

There are strong arguments for decentralization to lower levels of government:

Facilitates both he production of public goods at efficient levels and the matching of local goods to local preferences.

Brings citizens closer to public decisions, making it easier for them to voice their preferences about the quality and quantities of public goods.

It allows people to vote with their feet by moving to jurisdictions offering more preferred policies.

However, these benefits of decentralization come at a cost. While decentralization is a desirable feature of government, it:

Tends to hinder implementation of policies.

Allows for fiscal externalities to occur in association with the supply of local goods.

5.1 The implementation problem

Adopted policies gain force through implementation. The passage of a law, the adoption of an administrative rule or the issuance of a judicial order establishes policy goals and specifies the means necessary to achieve them. Implementation describes the efforts made to execute the means efforts that do not always achieve the established goals.

The greater the potential for persons or organizations to hold back contributions needed for successful implementation, the greater is the possibility of failure. Those who oppose the goals of the policy and those who do not view the goals as sufficiently beneficial to justify their own costs of compliance may purposefully withhold contributions. Others may do so simply because their resources and competence are too limited too allow them too comply.

In decentralized political systems, many officials have the capacity to withhold contributions. They thereby enjoy bargaining power that may enable them to extract things from those who need their contributions. Even when the central government has authority over lower levels, it faces the problem of monitoring their compliance.

Examples of good policies that fail in implementation?

Implementing policies requiring cooperation from lower-level governments becomes even more difficult when the central government does not have the authority to coerce. To induce cooperation, the central government must offer sufficient rewards to secure voluntary compliance.

5.2 Fiscal externalities

Decentralized permits local goods to be better matched to local demands. It also gives people some opportunity to choose the bundles of public goods they consume through their selection of jurisdictions.

Jurisdictions have an incentive to encourage some migrants and discourage others. Migrants who pay above average tax shares and place below average demands on public services are particularly desirable because they lower tax shares for everyone else in the jurisdiction without lowering service levels. In other words, they impart a positive fiscal externality to the established residents. The opposite holds for those who pay below-average tax shares and place above-average demands on public services. As taxes are often on property values at the local level, jurisdictions have an incentive to try and exclude those who would have below-average property values. This tends to lead to such local policies as minimum lot sizes, restrictions on multiple-unit dwellings and restrictive building codes that inflate construction costs. One social cost of those policies is a reduction in housing opportunities for low- and middle-income families.

5.3 Analysts in decentralized political systems

Political decentralization complicates the implementation process. It greatly increases the difficulty analysts face in trying to predict the consequences of alternative policies.

Also because analysts have clients throughout the political system, they often face conflicts between their own conception of what promotes the social good and the personal interests of their clients. Even the most basic question of whose costs and benefits should count often arises. For example, how should an analyst who works for a city major count the costs and benefits that accrue outside the city? From the social perspective we should take them into account, but what would the consequences be of taking them into account if other jurisdictions do not take into account the externalities of their policies?

6. Summary of government failure

Governments, like markets, sometimes fail to promote the social good. We often can not predict the exact consequences of government failures. However, we must be aware that they can occur if we are to avoid the most ineffective and unwise interferences with private choice. The basic sources of government failure are summarized in the box below.

Summary of basic sources of government failure

Problems inherent in direct democracy:

Paradox of voting (meaning of mandate is ambiguous).

Preference intensity and bundling (minorities bear costs of inefficient social choices).

Problems inherent in representative government:

Influence of organised interests (rent seeking).

Geographic constituencies (log rolling).

Limited time horizons induced by electoral cycles (under investment).

Posturing to public attention (restricted agendas).

Problems inherent in bureaucratic supply:

Agency problem (diversion of resources).

Difficulty valuing output (inefficiency from not knowing the optimal level of output).

Limited competition (inefficiency from lack of pressure to operate at minimum cost).

Civil service protections (inflexibility).

Bureau failure as market failure (allocative inefficiency).

Problems inherent in decentralisation:

Diffuse authority (implementation problems).

Fiscal externalities (unequal distribution of local public goods).

7. Solutions to government failure

7.1 Freeing markets

Markets provide a yardstick against which to measure the efficiency of government interventions. If we determine that there is no market failure, then we should consider the establishment (or reestablishment) of a market as a candidate solution for our policy problem. Of course, other values besides efficiency may lead us to reject the market solution as a final policy choice.

Freeing regulated markets should be considered in those situations where there is no inherent market failure. However, keep in mind that there may be relatively major windfall, or distributional gains and losses, once the current government intervention is eliminated.

It is useful to think in terms of 3 categories of freeing markets:

Deregulation. In many countries governments have engaged in price, entry and exit regulation of competitive markets. In the absence of market failure, these interventions create inefficiencies. Removing deregulation can be difficult. Vested interests have an incentive to retain the advantages they enjoy under regulation. Consequently, successful deregulation often requires vigorous advocacy that details the failures of the regulatory regime and allays fears about distributional effects. Remember that firm failure is not synonymous with market failure: consumer gains may more than offset employee and shareholder losses. Examples in Ukraine where deregulation may be a solution? Legalization. This refers to freeing a market by removing criminal sanctions.

Privatization. The word privatization is often used in several different ways:

1 The move towards user fees.

2 Contracting out of a good that was previously produced by a government organization.

3 The selling of state owned enterprises to the private sector.

4 Demonopolization or the process by which government relaxes or eliminates restrictions that prevent private firms form competing with government organizations

Only the last two of these are related to the freeing of markets. The presence or absence of market failure is the crucial issue in evaluating privatization.

Note that if a market has not existed previously it makes no sense to take about freeing it. Rather the process is one of facilitating the creation of a functioning market by either establishing property rights to existing goods or creating new marketable goods. We talked about some situations of market failure where government might need to take these approaches in workshops eight and nine. However, sometimes the lack of property rights may reflect a government failure. For example, the government created collective farms in Ukraine are likely to suffer the problem of the tragedy of the commons discussed in workshops eight and nine.

7.2 Simulating markets

In some situations where efficient markets can not operate, it may be possible for government to simulate market processes. Even when competition within a market can not be guaranteed, competition for the market may be possible. In other words, the right to provide the good can be sold through an auction.

One context where an auction may appropriately simulate a market is the provision of goods with natural monopoly characteristics. However, it is not efficient to auction the right to operate to the monopoly to the highest bidder. In a competitive auction the winner bidder would be prepared to pay up to the expected value of the excess returns from operating the natural monopoly. The winning bidder would then be forced to price accordingly, leading to the allocative inefficiency described in workshops eight and nine. A more efficient approach is to require bidders to submit the lowest retail price at which they will supply customers. Auctions are also often used to allocate the rights of publicly owned natural resources.

One problem with auctions is that the winning bidder has an incentive to cheat by reducing the quality of the good. To avoid this, specifications for the good must be carefully outlined and enforced. The end result between government and franchise may be similar to more traditional regulation.

7.3 Contracting out

An alternative to bureaucratic supply is contracting out. While market failure or equity reasons may mean that government wants to fund production of a good or service, it does not necessarily have to produce it itself. Government can finance goods or services that are delivered by a profit making firm.

Empirical studies seem to suggest that contracting out tends to be less costly than government provision. Those services that can be most easily contracted out are those that have tangible and easily measurable outputs. In these cases, monitoring the quality of output is relatively straightforward. The usefulness of direct contracting for services like health care is less clear, depending on the extent to which quality, quantity and eligibility can be effectively monitored and the possibilities for opportunistic behavior controlled.

Are there any goods that government produces in Ukraine that could be contracted out?

7.4 Transitional assistance

Efficiency enhancing policy changes are strongly resisted by those who suffer distributionally. This may result from the elimination of existing benefits or the imposition of new costs. Government may want to pay compensation, when its policies would increase aggregate welfare but would impose disproportional costs on particular individuals or localities.

Compensation may be monetary or nonmonetary. Non monetary payment typically takes the form of either a grandfather clause which allows a current generation to retain benefits that will not be available to future generations. Grandfather clauses can increase political feasibility, but they can also reduce effectiveness.

8. Homework

Continue to work on improving your problem analysis and on solution analysis. When identifying and evaluating alternatives, think carefully about whether any of your alternatives carry any risk of the types of government failure discussed in these course notes.

In addition, the last homework included a glossary of economic terms. You should add a number of terms from the topics covered in these course notes:

Paradox of voting.

Pareto efficiency.

Tyranny of the majority.

Rent.

Rent seeking.

Log rolling.

Sunk costs.

Principal agent problem.

Supply

Price

D

Px

C

A

Pe

B

Pc

Demand

Qd

Qs

Qe

Quantity

The details of the paradox of voting and Arrows impossibility theory are not covered here. For more information see Weimer and Vining, Policy Analysis Concepts and Practice, Prentice Hall, Englewood Cliffs, New Jersey 07632, 1997.

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