1. State and Local Public Finance Spring 2015, Professor Yinger Lecture 5 Public Sector Costs: Policy

2. 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

3. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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.”  This is a misnomer—it’s not really such a bad thing!

4. State and Local Public Finance Lecture 5: Public Sector Costs: Policy In 1967, an economist named Baumol (my micro professor) analyzed a 2-sector economy. His model has four key assumptions:  One sector has productivity gains, the other does not  The labor market is competitive, so the wage in each sector must equal MRP (also called VMP).  Labor is mobile between sectors.  The demand for goods in the unproductive sector is inelastic (as estimated for local governments!)

5. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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:  The relative cost of goods in the unproductive sector steadily rises.  Employment steadily shifts into the unproductive sector.

6. State and Local Public Finance Lecture 5: Public Sector Costs: Policy First, what happens in the labor market when productivity rises [MRP=(P Q )(MP L )]: MRP 1 MRP 0 Wage S0S0 S MRP S1S1 L 1 L 0 Labor L 0 L 1 Labor Sector with Productivity GainSector without Productivity Gain W0W0 W1W1

7. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Second, consider what happens in product markets when labor costs rise: Demand MC 1 $ MC 0 Demand MC 1 S 1 S 0 S Q 1 Q 0 Q Sector with Productivity GainSector without Productivity Gain P0P0 P1P1 $ P1P1 P0P0

8. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Third, go back to labor markets to consider price increases [MRP=(P Q )(MP L )]: MRP 1 MRP 0 Wage S0S0 S1S1 MRP 1 S1S1 L 1 L 0 L 2 Labor L 0 L 2 L 1 Labor Sector with Productivity GainSector without Productivity Gain W0W0 W1W1 MRP 2

9. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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.

10. State and Local Public Finance Lecture 5: Public Sector Costs: Policy But a more likely explanation is that these trends reflect “Baumol’s Disease,”  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!

11. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Regardless of the role played by “Baumol’s Disease,” 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:  Observe  Experiment  Evaluate!

12. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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:  to select programs and reforms that appear to have worked in other places  to design new programs and reforms

13. State and Local Public Finance Lecture 5: Public Sector Costs: Policy But evaluation should always be in the back of your mind.  Search for evaluations of the programs or reforms you are interested in.  Make an honest judgment about the quality of existing evaluations.  Informally apply basic evaluation principles to programs and reforms you are considering.  Implement formal evaluations whenever possible!

14. State and Local Public Finance Lecture 5: Public Sector Costs: Policy What is the basic problem facing someone wanting to evaluate any public program?  What you want is to know how one place differs with and without the program.  What 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.  Thus, you cannot be sure that the effects you observe are not due to non- program differences over time or across places.

15. State and Local Public Finance Lecture 5: Public Sector Costs: Policy The two ways to solve this problem are  random assignment  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.

16. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Random assignment is the preferred method in most cases. It provides results that are intuitively compelling and scientifically sound. If you believe in cutting costs, become an advocate for evaluation using random assignment!

17. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Random assignment has been used to study:  Welfare-to-work programs  Unemployment insurance  Job training  Income maintenance  Housing assistance  Electricity pricing  Education (e.g. Charter Schools)  Early childhood development  Criminal justice policy  Child health and nutrition

18. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Random assignment is not always feasible. The best statistical studies:  Must have extensive data to ensure that differences aren’t due to unobservable factors.  Must have comparable treatment and control groups based on observable factors, which often requires new “matching” methods.  May have multiple observations over time so they can “difference out” unobservable factors.

19. 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.

20. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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.

21. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Production Arrangements Include  Contracting out to a private firm  Contracting out to another government agency  Outsourcing, i.e. purchasing from a private company  Use of vouchers to finance private production  Intergovernmental cooperation (to gain economies of scale)

22. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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.

23. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Consider the following ways to move away from delivery by a single public agency: Charter Schools Public School Vouchers Private Electric Company No-bid Contract PrivatePublic Public Agency Monopoly Competition Private School Vouchers Bids & Contract

24. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Although competition is likely to cut costs, the impact of privatization on costs is not so clear:  Private firms are probably more likely to innovate because it boosts their profits.  But private firms are also more likely to cut corners or to neglect social concerns—if their contract allows.

25. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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  Specifies performance standards  Provides clear incentives to meet those standards

26. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Contracting out to private firms can work well if:  The relevant market is competitive and bidding is possible  The performance objectives can be clearly specified in the contract  A firm’s performance can be monitored  Financial rewards and/or penalties can be written into the contract, too.

27. State and Local Public Finance Lecture 5: Public Sector Costs: Policy Big Problem Number 1:  Cost savings are almost impossible to document.  Cost savings only exist when full costs are lower, holding performance constant. But many costs are hidden. And performance usually cannot be measured.  Beware of cost-savings claims!

28. State and Local Public Finance Lecture 5: Public Sector Costs: Policy 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!