Public Production of Goods

and Services
Chapter Eight

‘Economics of the Public Sector’ (4th Edition)

Joseph E. Stiglitz and Jay K. Rosengard
2 Introduction
Part One (ROLE & SIZE OF PUBLIC SECTOR) comprised of two chapters
Defining Public sector responsibilities (Chapter One)
Measuring Public Sector Size (Chapter Two)
Part two (FUNDAMENTALS OF WELFARE ECONOMICS) has five chapters
Market Efficiency (Chapter Three)
Market Failure (Chapter Four)
Public Goods and Publicly Provided Private Goods (Chapter Five)
Externalities and the Environment (Chapter Six)
Efficiency and Equity (Chapter Seven)
Part Three (PUBLIC EXPENDITURE THEORY) has two chapters
Public Production of Goods and Services (Chapter Eight)
Public Choice (Chapter Nine)

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *

 Choices of Public Provision of Goods &
3
Services
Privately produced public goods through sub contracting
Building Roads through private contractors
Publically provided public goods (Non-Rival & Non-Excludable)
Government itself chooses to produce these goods & Services
Armed Forces producing and providing defence services

Publically produced Private Goods & Services (Rival & Excludable) for their MERIT
Health & Education
Publically provided club goods (Non-Rival but Excludable)
Postal Services, Telecommunications with changing trend
Public provision of Common Goods (Rival but Non-Excludable)
Development of a tourist resort with public exchequer

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *

 Common Grounds of Public Provision of
4
Goods & Services
Unviable Competition
causing customer exploitation whereby government intervenes in two ways
Direct provision of Goods & Services
Like NBP, Electricity, Gas

Regulating the actions of private firms through

Price controls

Quality Controls (Food & Drugs regulatory Authorities)

There is a shift away from public production to private production (with regulation)
especially in Gas, electricity, telecom and transportation (Air, road and Rail) sectors

Public Interest
Served by the Government like
National defence for collective national welfare
Public schools for promoting national values not just skills
Support of a specific industry (like textile)
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
Nationalization by taking control of key economic sectors
 Difference between ideology-driven and
5
circumstances-driven Nationalization
Nationalization of some Swedish banks in 1992 and nationalization of several severely
distressed financial institutions in the United States in 2008,
These government takeovers are meant to be temporary, as indicated by the terms and form of
the takeover
There is often a timetable for the public sale of the government’s stake
Adoption of conservatorship model

purchase of preferred (nonvoting) shares signal the government’s desire to refrain from engagement in the
business’s day-to-day operations

The question is how to balance circumstances-driven Nationalization

Letting failing enterprises to fail or
Giving them a chance to survive
How to give those chances

Taking control of these enterprise or Corporatizing those enterprises

The rest of the chapter is meant for better understanding of how to strike that balance
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
 Natural Monopoly: Public
Production of Private Goods

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *

 The two Sides of competition in the Markets
7
INTERVENTION in the market is provoked by a market failure
The most frequently cited MARKET FAILURE is lack of competition
Firms’ strive to GROW over time to gain Economies of scale
ECONOMIES OF SCALE enhances efficiency of these firms over their rival firms
If one firm serves the whole market more efficiently than the same market is served with
multiple providers, it is called NATURAL MONOPOLY
Government may assume the role of natural monopolist fearing that a private provider is
likely to be EXPLOITATIVE by
Charging higher prices
Restricts availability
Government therefore chooses to provide many excludable but non-rival goods and
services where the cost of additional supply is higher under competition than monopoly
Water supply, electricity, Cable TV, Natural gas supply etc.

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *

8 Why Average cost may decrease
TOTAL COST has two components
FIXED COST may include cost of building and
infrastructure
It goes down as production increases
The (fixed) RnD cost ($10 million) of preparing a Vaccine is (on
average) $10 million for the 1st Vaccine and $ 5 million for 2
vaccines; $ 1 for 10 million vaccines and 10 cent for 100 million

VARIABLE COST may include cost on workers and

materials
If we assume that the cost on workers and materials remain
stable
Lets say it takes $10,000 for a batch of 1000 vaccines ($10 per
vaccine and remains the same)

If the variable cost remains then same the average

total cost continues to decline which is called
Economies of Scale – as you produce more output
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
 The Introduction to Revenue Curves
Users Or TR AR MR Incremental Revenue (MR) is
Uses compared with incremental
AR is Average Revenue
Cost (MC) by profit driven
(popularly called price) charged
per unit from the users.
0 0 - - supplier who would sell as
long as MR is greater than
1 10 10 10 MC.
TR is total revenue from the sale of
output (AR * users or uses = TR) The positive difference
2 18 9 8 between average revenue &
MR is change in TR with additional average cost is per unit profit
use. Although 6 people used the 3 24 8 6 (it is maximum when MR=MC
facility by paying RS. 5 per unit such that MC cuts MR from
below). Q* on slide 11
and RS. 30 were collected, yet 4 28 7 4
the TR remains as was collected
If the seller continues to sell
from 5 users at the rate RS. 6 per
unit. AR remains more than MR
5 30 6 2 for MR that is below MC, per
unit Profit continues to
after the sale of first unit.
decline, so much so that
6 30 5 0 AR=AC (zero per unit profit).
Q1 on slide 11.
 • Cost Curves are called Supply
curves & Revenue Curves are
called demand curves and are
considered to represent the
Users Or TR AR MR value to the buyer
• AR for average value
Uses • MR for incremental value
’
0 0 - - Price

1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4 Demand

5 30 6 2
0 1 Quantity of Output
6
6 30 5 0
For any level of output blue line
Those who cant afford at higher price (price or AR) is more than
are allowed to use with lower price. incremental revenue (MR).
 11
The Basic Economics of Natural Monopoly
Q* Output with no threat of a rival

Q1 Output with Threat of a rival

entry & No sunk cost
Q1-Q* Increasing sunk costs & fading
threat of rival entry causes output
to shrink from Q1 to Q*
(Zone of Contestable Markets)

Q0 Efficient level of output with loss

that needs to be covered through
subsidy, by the size of red arrow per
unit of output with the assumption
that govt. would know the size of
subsidy. There will still be questions
like where to raise the revenues for
subsidy (even if there are no costs
of raising the revenues.
*
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi
12
Effects of Sunk Costs on Monopoly Settings
Sunk costs are the expenses on items that can not be recovered
Building may be used for another purpose if the business shuts down (Cost is recoverable)
Some infrastructure may be of no use if the business is shut down (Irrecoverable Cost)
RnD costs, Celebrity endorsements are examples of sunk costs

Monopolists attempt to avoid (possible) contest in the market by incurring heavy

sunk costs, which increases the threat of exploitation by the monopolist
Increasing prices
Restricting output
If irrecoverable (Sunk) costs are very high the entry of a rival firm is unlikely despite
high profits to the existing firms.
New entrant fears that he will not ne able recover the sunk costs, if he it fails because the
Monopolists has profits earned over the years helping him
to cut prices long enough to drive the competitor out of the market

Government therefore has role to play in natural monopoly settings

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
13 Multi-product Natural Monopolies
If monopolist is asked to charge a price (AR) equal to its MC, it would require subsidy
In order to avoid paying subsidy, monopolist must be allowed to charge price (AR) in
excess of MC on the basis of elasticities (price sensitivities) of the user groups
Multi-Product natural monopolies could be helpful in this scenario
Natural monopolist can be allowed to charge more for some products (AR>MC) and less
for other products (AR<AC) to cross subsidize customers across products
Products with less elasticity be charged higher and those with more elasticity be charged less
The decrease in purchase of product with less elasticity will be LESSER than the increase in the purchase of
product with more elasticity

Increase revenue from less elastic product could be used to cross-subsidise the users of more elastic product

Natural monopolist of postal services may charge a higher price for urgent postal deliveries (less elastic)
to cross-subsidize normal postal deliveries (More elastic)

Natural monopolist of power supply could do the same for users of electricity

The issue of cross-subsidy is deeply political for its consequences across groups for
politically determined elasticities and prices.
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
14 There is less decrease in
demand (horizontal axis) for
the same ‘Price increase’
(on vertical axis) in Case-A
[less elastic] than in Case-B
[more elastic].

The multi-product
monopolist may be allowed
to charge higher price in
Case-A to cross-subsidise
users in Case-B

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *

15 Natural Monopoly and Role of Government
There are two possible choices for the government to deal with potential exploitation by
natural monopolies, each with its own consequences
Take over production
It is generally believed that government is good at managing production
The case of Pakistan Steel Mill

Regulation through price setting or subsidies

Price regulation so that monopolist does not exploit
Provision of subsidies to encourage monopolist to goods or services that are not profitable

There are sectors of successful transition as well as struggling transformation in

Regulation (The case of Private Schools)
Privatization (The case of KESC)
Non-competitive
Civil Services Academy & Non-transparent process
48th CTP Muhammad Salahuddin Ayyubi *

Incomplete privatization contracts causing excessive litigation due to

 Critical Evaluation of Possible Choices
16
Advocates of regulation cite advantages of regulation over public ownership
Creating local private efficiency based monopolies doing better than running one big
government enterprise all over the country
A private supplier has a better idea of cost streams in the local context than a centralized
government for a given desired objective.
There are challenges with regard to regulation also like
costs associated with regulatory administration and limited government capacity
Market distortions being caused by regulation
The advantages of regulation are generally believed to be in excess of the challenges
in most of the cases which led to the wave of privatization
The role of ‘special interest groups’ in Privatization and regulation has created appeal
for ‘De-regulation’ which has its own challenges of corporate misadventures due to
irreconcilable differences (case of private sector prisons) between
Public policy objectives (Rehabilitation of prisoners as normal citizens)
Private Sector priorities (Retention of the customers for which they will be compensated)
Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *
17

Critical Evaluation
of Possible Choices

Civil Services Academy 48th CTP Muhammad Salahuddin Ayyubi *