Public Production and Bureaucracy FOCUS QUESTIONS 1 What is the role of government in production? What is the rationale behind government production of goods and services such as electric utilities and water? Why are these called natural monopolies, and what are alternative ways by which abuses of monopoly power might be prevented? 2 Why is production in the public sector often less efficient than production in the private sector? What are the dangers and limits of privatization? This chapter is concerned with the role of government in production Chapter 4 identified several market failures, When there is a market failure some form of government intervention is required, For instance, Chapter 6 explained why there will be an undersupply of public goods, and described the efficient level of provision of public goods. But government does not have to produce these goods; all it has to do is pay for them. There are sublic goods which are privately produced. ‘Phere ave also many pri- ;o0ds which are publiely produced, stich as postal services and wilities Exen though marker failures provide a rationale for some form of gov emment intervention, they do not, by themselves, provide @ rationale for government production, Yet there are certain areas in which production dominates, and others ia which itis very commonly used. For 189[AND BUREAUCRACY 190 instance, with few exceptions, governments have not relied on mercenary armies, In most countries governments run the school systems, and in al most all countries, the postal system, And, until a few years ago, in most countries governments ra public utilities such as telecommunications, Two common threads run through these examples, First i many of these ceases, competition is not viable. Res nber, markets resulk in efficiency when they are competitive, Historically, only one firm has provided postal services aid one company has provicied telephone services, Without government interven: ‘on one firm, ot a few firms, would be able to exercise mi Ket power and ex: ploit consumers. Governments have intervened in two ways. In the past, most jovernments have chosen t0 « fe charge of the industry directly, providing telephone services or electricity. Asan alternative to producing the goods it self, however, government can regu te private firms—for example, by control ling their prices—to ensure that they do not exercise their monopoly power In tive last several years, there has been a shift sway from public production to- ‘ward private production with regulation, This process of privatization has been particularly marked in Europe and Japan, and in utilisies (ike gas, electsieity, and telecommunications) and tran ‘portation (railroads and airlines The other common thread in many of the examples af govern nent pro. duction is that the public interest has mau Gimensions. Will the actions of profirmaximizing firms reflect these broader publie interests? There is often, no simple way government can intervene to ensure that they do. This is why the government does not contract out to private firms to run the national defense system. It does contract out specific activities, such as building ships or airplanes, But it does not say t0 a private firm, "Rum our defense establish ment in Europe.” Similatly, some believe that schools serve a variety of social functions, which go beyond conveying skills and knowledge. They transmit national values and help form a sense of nationhood, There is concer that a private school system, as tive as it might be in imparting skills, might not work as effectively in advancing this hroader set of public objectives, While limitations of markets (such as limited competition) and con: cerns about broader objectives provide motivations for public production, there is one compelling argument against public production: Often, govern: ments seem to be inesficient producers. Thus, ideatifying when goverament should eng: age in production and when it should use private firms involves a balancing, To understand better the nature of the balance, we begin by tak Ing a look at goverment production of private goods, where issues of "So ial values” enter in a much more Limited way. The primary concern is that the private good—eleciricity, mail service, or telephone service—be prow vided in the nost efficient way at the lowest possible cost to consumers, NATURAL MONOPOLY: PUBLIC PRODUCTION OF PRIVATE GOODS The most imporians marker failure that has led to public production of vate goods arises when markets are not competitive, This provides at least part of the explanation for government production in. postal services‘THE BASIC ECONOMICS OF NATURAL ‘monoPoLy telecommunications, water, harbors, electricity, As we saw in Chapter 4, a common reason why markets nay not be competitive is the existence of in- creasing returns to scale; that is, the average costs of production decline as the level of praduction increases, In that case, economic efficiency requires that there be a limited number of firms. Industries where increasing returns are so significant chat only one firm should operate in any region are re- ferred to as natural monopolies Water is a good example, The majar cost associated with delivering water is the network of pipes. Once pipes have been installed, the additional costs of supplying water to one extia user are relatively insignificant, It ‘would clearly be inefficient to have side by side, one delivering t© one home, the next to a neighbar’s. The same is true of elec- tricity, cable TV, and nanural gas. sso networks of pipe The average cost curve and the demand curve for a natural monopoly are represented in Figure 8.1, Since the avera the level of praduction increases, itis efficient to have only one firm. In the case depicted, there is a whole range of viable outputs (where the frm makes a profit), The maximum viable output (sithout subsidies) is Q,, where the demand curve intersects the average cost curve costs of production decline as _Profit per unit = difference between price fand average cast Demand Monopoiist's profit, Marginal Average cost Marginal a Monopoly output Natural Monopoly With no sunk costs and potential entry, a natural monopolist would operate at Q,, the lowest price consistent with at least breaking even, With sunk costs, the price will be higher. The monopolist lnconcerned with the threat of entry operates at Q*, where marginal revenue equals marginal cost. 191[AND BUREAUCRACY 192 In these situations, we cannot rely on the kinds of competitive forces that ‘we discussed earlier to ensure that the industry operates at the efficient level Efficiency requires that price equal marginal cost (at quantity Qp). Buc if the firm changes a price equal to marginal cost, it wil suffer loss, since marginal cost is lower than average cost for industries with declining average cost One common recommendation in this situation is for the government to provide a subsidy to the indust at the firm charge a price equal to the marginal cost. This policy ignores, however, the question of how the revenues required to pay the subsidy are to be raised; in particular i assumes that there are no costs associated with raising this revenue. More- ‘over, it assumes that the government knows the magnitude of the subsidy that will enable the firm to be viable In practice, most governments have attempted r make such industries pay for themselves. (They may also be concerned with the equity of making enteral taxpayers pay to subsidize a private good that is enjoyed by only portion of the population, or enjoyed by different individuals to differen: extents.) Thus they hate insisted on governmentananaged natural monopo- lies operating at the intersection of their demand curves and their average ‘cost curves (Q, in the figure). This is called the zero profit point. The zero profit point is precisely the point where natural monopolies may operate, under the assumption that there is effective potential compet tion, Assume a firm ied to charge a price that exceeded the average cost of production. If it were easy to enter (and exit) from an indusoy, a firm that tvied to capture a profit for itself would instantaneansly be threatened with entry by other firms willing to provide the given service or commodity at a lower price. New firms could come in and provide the services or commod ties ata profitable price, without worrying unduly about the reactions of the original firm.! ‘Thus the presence of a single firm in an industry does not, ia itself, imply that the firm can exercise monopoly power. So long as there are potential entrants, that single firm must charge « price equal to average cost and insist d EFFECTS OF SUNK COSTS All of this changes when there are sunk costs. Suni costs are costs thal are not recov search and development expenditures represent sunk costs. But a building shat can he converted costlessly into another use does not represent a sunk. cost, An aigplane, which can easily be sold to another airline, does not rep resent a stink cost Why are sunk costs so important? They create an essential asymmetry between a firm that is established in an industry, and one that is not, The able upon the exit of the firm. Most re "In the recent literature on indus al organiuation, markets with decreasing ave tage costs but no sunk costs, in which price 1s maintained ata level equal to average cons, are refersed co as comtetable. See W. J. Baal J Pasurar, aan R. Will, Con testable Markets and the Theory of Industrial Oiganization (New York; Harcourt Brace Jo ;novich, 1982), For a simple exposition of the theory ol contestable markets, see W J. Baurnol, “Contestable Markets: Aa Upris “American Econom Review 72 (1982) 1-15, in the Theory of Industey Structure[NATURAL MONOPOLY: Pustic PRODUCTION oF Private GooDs potential entrant is not ia che same position as the firm already in the indus: Uy, for the firm already in the industry has expended funds that it cannot recover, In deciding whether to enter, a firm does ot look at the level of current profits and prices, but at what prices and profits will be after entry Even iff prices currently are considerably above average costs (so profiss are large), a potential entrant may well believe that the firm already in the ir dustry will respond to entry not by exiting the industry but by lowering its price; at che lower price, entry no longer is profitable. Moreover, when sumtk costs are significant, an entrant worries that it will not be able t0 recover all the expenditures it makes upon entry. Thus, it will be reluctant to gamble ne current firzn will either exit or leave its prices at their currently high thi levels, Accordingly, sunk costs act as 8 barrier to engry and allow the estab- lished firm a degree of monopoly power that it could not exercise otherwise, Since virtually all natural monopolies entail important sunk costs, che government carinot sknply rely on the threat of potential competition, The nwals consumers’ water or electricity gives rise to fact that a single firm c concer: the monopolist is in a position to exploit its consumers. The mo- nopolist who is unconcerned about entry by ather firms charges a price that maximizes its profits, the price where the marginal revenue it gets from sell ing an additional unit is equal to the marginal costs (output Q in Figuse 8.1), [ts profit per unit of output is the difference between the price ic charges and the average costs, MULTIPRODUCT NATURAL MONOPOLIES So far, we have focused on @ natural rionopoly producing a single commodity. Ifthe industry is nat to be subsi ized, it must charge a price in excess of marginal cost ‘On what principle should prices be set when a natural monopoly pro- duces several commodities? Prices, on average, will sill need to exceed mar ginal cost if the firm is to break even. Should, for instance, the ratio of the price to marginal cost be the same for all the firm's products? Should higher charges on somne services be used to subsidize ather services? For example, the U.S. Postal Service imposes uniform charges for deliv ring mail, even though the marginal cost of delivering mail to a rural household in North Dakota may he much higher than the cost of delivering a letter in Chicago. If the post office is to break even, there must be a eros: subsidy, a subsidy from one user (product) co another user (product) The issue is obviously very political; the elimination of cross subsidies will affect some groups adversely. When pricing decisions are made politi cally, these groups will attempt to persuade those in charge to lower the prices to them, implicitly raising prices to others. The analysis of pricing decisions involves both efficiency and distribu sional considerations. Economists have been particularly concerned with politieally detersined pricing policies, When prices nption of thar service declines, but a 1 jorls han for other the efficieney costs are saised on some service, the cons. percent price increase reduces demand more for some goods. Goods for which demand is more sensitive to price inereases are said to be price elastic, Figure 8.2 shows an inelastic demand curve, for which a change in price does not result in a very large change in consumption, 193FIGURE 8. Demand curve (inelastic commosity) Price f ~ increase Marginal cost aor oat weaast{ Marginal cost Demand curve (elastic commodity) oF Onn Pricing in a Multi-Commodity Natural Monopoly (A) With an inelastic demand, an increase in the price above marginal cost results in a relatively, small decline in output. (8) With an elastic demand, an increase in price above marginal cost results in a large decline in output. 194 while in Figure 8.25 the demand is very elastic; a change in price results in large change in consumption. Hf natural monopoly is to break even (without government subsidies it obviously must charge a price in excess of marginal cost, If the govers ment increased price above marginal cost by the same percentage for 3! tic demand would be commodities, clearly consumption of goods with el reduced by more than consumption of goods with inelastic demand. Under some circumstances it can be shown (© be desirable to charge prices such that consumption of every good is reduced by the same percentage (from what it would be if price equaled marginal cost). Ifthe government wishes to do this, it should increase the price {above narginal cost) more for comREGULATION AND ‘TAXATION (SUBSIDIES) modities whose demand is inelastic than for commodities whose demand is elastic? When there is a natural monopoly with sunk costs, there isa danger that the ionopolist will take advantage of its position and charge a high price, One way of addressing this concera, as we have seen, is for government to take Buc there has been increasing concern that governments over production do not do a good job at managing production. Rather than attempting to produce the good itself, the government may leave production to the pri xate sector, but regulate prices to ensuce that the firm does not take advan- age of its monopoly position. Moreover, it can use subsidies to encourage the firm to provide services that might not he profitable privately but are viewed as socially desirable, such as providing postal service :o rural areas Those who advocate regulation and subsidies (or taxes) as remedies for market failtrres believe that they have three major advantages over public ownership, Fisst, hey allow for a more consistent and efficient national pol icy. Assume that it is desirable to locate firms in some area with high unem- ployment. Because of this, government-run firms are often told to locate in such areas. Its, however, beter fo provide a general subsidy, with those firms for whorn the snove has the least cost ciking sdvantage of the subsidy, than t© simply impose the burden on those firms that happen to be government run. Second, the utilization of tax and subsidy schemes allows a clearer esti mate of the costs associated with pursuing a given objective. It may be desir able to reduce the level of pollution, but how much is it worth? Tt may be de- sirable to locate a firm in an area where there is high unemployment, but * This policy will minimize the deadweight lass resulting from price exceeding mar inal cost, The problem of haw 10 set prices for 2 multicommadcy publie monopoly ‘was first solved in 1956 hy Marcel Boiteux, whe served as the director of Electricité de France, the goxesnment agency in France responsible for producing electricity For an English staoslation, see “Oa the Management of Public Monopolies Subject co Budgetary Constraints,” journal of Beonome Phew § (1971): 219-40. This question of the determination of prices for different commodhties rns out to be equivalent to a stnilar question posed some twensylive yeurs earlier by the great British econo: jovernient must raise 2 given amount of revenue by dis Should i, for instance, change a would nist Frank Ramsey: Wf the g ortionary taxation, How should ic raise the revent tuniform tax on all commodities, so thatthe ratio of the price to marginal & be the same for all commontties? Would there then be no relative distortions? Rar sey showed that, a8 plausible as that might seem, 2 uniform tax was not the correct answer; it was preferable to charge a higher tax on a commodity whose demand was inelastic, Both Ramsey and Boiteus ignored the distributional istes that are contral to most of the political debate. These were introduced into the analysis by M. Feld= stein, “Distributional Equity and the Optimal Sicuctare of Public Prices,” American Economie Review 62 (1973): 32-36; and {in the context of taxation) by P. Diamond and J. Mirtlees, “Optimal Taxation and Public Praduction,” American Keonamic Re view 61 (2971): 251-78, andl A.B. Atkinson and J.P. Stiglitz, “The Structure of Ini ree: Taxation and Feonomic Efficiency,” journal of Pubtic Beonomies (1972). 97-119 and “The Desiga of Tax Structure: Direct versus Indizeet Taxation,” Journal of Publi 6 (1976), See also below, Chapter 20, Foon 195[AND BUREAUCRACY 196 NO GOVERNMENT INTERVENTION how much is it worth? Its often difficult :o ascertain: the additional costs of government extexprises’ pursuing alternative objectives; providing direct, government subsidies brings the costs more into the open and thus allows a more rational decision concerning whether the costs are worth the benefits ‘Third, there is a widespread belief that incentives for efficiency are greater with private firms, even with regulation, In the case of natural monopolies, the United States has long relied on regulation (though there is some government production, particulaely of hy depelectric power and water), in contrast to Europe, which until recently re- lied on government ownership. Regulation is not without its problems: there are significant coss to administering te regulations, and almost any regula tory scheme gives nse to distortions (thatis, deviations in their behavior from. what efficient, competitive firms would do), as private fi their profits, given return on capital, ns wy to maximize he regulatory rules, Thus, if regulations allow a particular ‘here may be an incentive to invest too heaxily in capital; if they allow more generous depr ation allowances for one type of eapital than, another, this too may distort the investment decisions, In spite of these prob- leans, beginning in the 1970s and 1980s there was a major movement through. out the world toward privatization, that is, the selling off of government owned enterprises, and subjecting them to regulation. The advantages of gains in efficiency overwhelmed any disadvantages associated with regulation Somte economists, including Harold Demset of the University of California at Los Angeles and the Inte George Stigler of the University of Chicago. question whether it enight be better in most cases to just let the private sec tor alone, even with natural monopoly. Monopolists are efficient; the only problem with them is that they charge too high a price, and accordingly produce too little. But Amold Harberger, in a famous calculation, esti mated that the loss from monopoly pricing is relatively small (less than percent of the value of owtput Monopolies reduce production relative the efficient level; but the resources not used by the monopolist go else where in the economy. The loss is the difference in the marginal values 0: the two uses. The cumulative loss in efficiency {rom either regulation’ o government production, these economists believe, may be much greater 5 Sigler has argued, further, tat regulation may be inesectve, as the tegulat group “captures” the regulators, partly because the only people who ace wll formed on the highly sechnical macters of regulation are the regu partly because tive eulatars often get lierative jobs in the rea they Ingve dies vegulawory pasion haved industry Though the regulations way be ineffective wn limiting the regulated enti profit, the regulations may stil be highly distortionary. In recent years, there hia been problems on the other side: elected regulatars may follow populist policie driving down prices to che paint that the wily has litle incentive co invest furte George J Stigler, “Free Riders and Collective Action: An Appendix to Theories of Economie Regulation,” Bel Jounsal of Feunomies and Management Srience5, aut 1974, pp. 359485; and "The Theory of Economic Regulation,” Bal! Journal of E tes and Management Scimce2, spring 1971, pp. 3-21NATURAL MonaPoLy: PUBLIC PRODUCTION OF Paivate oops GOVERNMENT PRODUCTION OF PRIVATE GOODS Examples Postal Service, utilities Rationale: Market failure—lack of competition associated with natural monopoly Problems: Inefficiencies associated with government production Cross-subsidization issues Intervention of political concerns Alternatives: Regulation Ignoring problem (all known cures worse than disease) Current trends: Privatization Focusing government involvement on natural monopoly core, encouraging competition where feasible Most economists remain skeptical. They see larger losses from natural monopolies, partly hecause managers in industries not subject to compet tion (and not subject to the scrutiny of regulators) have a tendency to be come lax, and partly because, in the absence of competition, incentives to rnnovate may be limited. ‘Whether for thes fegulations of natural snonopolies remains limited. But there remains cos siderable interest in narrening the scope oF regulation, It is now recognized that there is more scope for competition than had been previously realized: wort for eliminating or for other reasons, popular suj for instance, several firms now provide long-distance telephone service, and there is a multitude of generators of electricity, There is still some natural monopoly—only a single firm provides local telephone service or electricity to most homes. Today, regulation is focused on ensuring that there is compe- tition where competition is viable, and that those parts of the system where NATURAL MONOPOLY «+ Efficient production entails only a single firm: + Market equilibrium will be characterized by a lack of competition. + Provides rationale for government production or regulation 197NATIONAL PERFORMANCE REVIEW ‘The problems of government inefficiency, particularly arising out of procurement and personnel policies, were the subject of a major review under the direction of Vice President Albert Gore. A report was issued in September 1993. The basic theme was that procurement and personnel policies had to be revised substantially in the process of reinventing government. The report emphasized greater reliance on, performance measures, greater use of market incentives, and greater use of commercial procurement practices (Our government, built around a complex cluster of monopolies, insulates both managers and w government to put the customer first by injecting the dynamics of the marketplace. The best way to deal with manopoly is to expose it te competition. rkers from the power of incentives. We must force our Elsewhere, the repart argued that “competition is the one force that gives public agencies no choice but to improve.” Competition is enough to force the private sector constantly to “reinvent” itself, to look for better and more efficient ways of doing what it does. But it is political pressures—including the pressure of a 198 there is a natural monopoly do not abuse their monopoly power, either by leveraging their monopoly power to gain further control ar by raising prices -o make high rates of return, Major reforms in telecommunications and in electricity regulation in 1996 reflected these changed perspectives. COMPARISON OF EFFICIENCY IN THE PUBLIC AND PRIVATE SECTORS Anyone who follows the news media has encountered shocking stories of government inefficiency, often citing misguided procurement policies fea turing $1000 coilet seats, $400 hammers, and the like. Sinnilar accounts have been issued from the private sector, such as the quest of cigarette compa nies to create a smokeless, safe cigarette, While stories of government inetf ciency draw enormous attention, and have helped create an image of inet cient government, there is some systematic evidence that reinforces the anecdotal evidence. Comparisons of costs of government and private firms engaged in similar activities tend to show substa firms, whether in housing ntially lower costs for private ¢ collection, bus transportation, payroll processing, or environmental cleanups, Even so, hard evidence on goxernment inefficiency is difficult to come by. For che most part, the governsnent and the private sector do not pr