lecture 5 public sector costs: policy state and local public finance professor yinger spring 2016

LECTURE 5PUBLIC SECTOR COSTS: POLICY

State and Local Public FinanceProfessor Yinger

Spring 2016

Baumol’s Disease

Evaluating Policies to Promote Productive Efficiency

The Role of Competition

State and Local Public FinanceLecture 5: Public Sector Costs: Policy

Class Outline

Today we will discuss ways to promote productive efficiency in the

public sector.

Before turning to this topic, however, we will gain some perspective on

it by discussing something called “Baumol’s Disease.”

o This is a misnomer—it’s not really such a bad thing!


Baumol’s Disease

In 1967, an economist named Baumol (my micro professor) analyzed a 2-sector economy.

His model has four key assumptions:

1. One sector has productivity gains, the other does not

2. The labor market is competitive, so the wage in each sector must

equal MRP (also called VMP).

3. Labor is mobile between sectors.

4. The demand for goods in the unproductive sector is inelastic (as

estimated for local governments!)


Baumol’s Assumptions

Wages rise with labor productivity in the productive sector

but also must rise in the unproductive sector because of labor mobility.

This leads to some startling conclusions:

o The relative cost of goods in the unproductive sector steadily rises.

o Employment steadily shifts into the unproductive sector.


Baumol’s Conclusions

First, what happens in the labor market when productivity rises [MRP=(PQ)(MPL)]:

MRP1

MRP0

Wage

S0

S

MRP

S1

L1 L0 Labor L0 L1 Labor

Sector with Productivity Gain Sector without Productivity Gain

W0

W1


Mobility Between Sectors

Second, consider what happens in product markets when labor costs rise:

Demand

MC1$MC0

MC0

Demand

MC1

S1 S0 S

Q1 Q0 Q

Sector with Productivity Gain Sector without Productivity Gain

P0

P1

$P1P0


Responses to Price Increases

Third, go back to labor markets to consider price increases MRP=(PQ)(MPL)]:

MRP1MRP0

Wage

S0

S1

MRP1

S1

L1 L0 L2 Labor

L0 L2 L1 LaborSector with Productivity Gain Sector without Productivity Gain

W0

W1

MRP2


Net Impacts in Labor Markets

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.


Leviathan?

But a more likely explanation is that these trends reflect “Baumol’s

Disease,”

o Which is nothing more than an inter-sector shift as productivity

gains make a society richer.

In this view, the cost of the public sector does increase over time, but

this trend just preserves levels of local public services—and we can

afford it!


Interpreting Baumol’s Disease

Baumol’s disease does not apply only to public services.

Several scholars have applied it to the arts:

o Technology cannot replace the actors in one of Shakespeare’s plays.

A recent column in the New York Times applied it to higher education:

o Mankiw, “Three Reasons for those Hefty College Bills” http

://www.nytimes.com/2015/12/20/upshot/three-reasons-for-those-hefty-college-tui

tion-bills.html?hpw&rref=upshot&action=click&pgtype=Homepage&module=well-r

egion&region=bottom-well&WT.nav=bottom-well&_

r=0


Other Examples of Baumol’s Disease

http://www.nytimes.com/2015/12/20/upshot/three-reasons-for-those-hefty-college-tuition-bills.html?hpw&rref=upshot&action=click&pgtype=Homepage&module=well-region&region=bottom-well&WT.nav=bottom-well&_r=0





Regardless of the role played by “Baumol’s Disease,” productive

efficiency is a good thing.

So how can public officials lower costs and hence cut taxes (or raise

service quality without raising costs)?

The answer:

o Observe

o Experiment

o Evaluate!


Boosting Productive Efficiency

Formal evaluation of programs or management reforms are usually not available.

Thus, it is appropriate for you (when you become public officials!) to use your own judgment:

o to select programs and reforms that appear to have worked in other places;

o to design new programs and reforms.


Step 1: Use Your Judgment

But evaluation should always be in the back of your mind.

o Search for evaluations of the programs or reforms you are interested in.

o Make an honest judgment about the quality of existing evaluations.

o Informally apply basic evaluation principles to programs and reforms you are considering.

o Implement formal evaluations whenever possible!


Step 2: Use Evaluation Studies and Principles

What is the basic problem facing someone wanting to evaluate any

public program?

oWhat you want is to know how one place differs with and without the program.

oWhat you observe is either (a) what the world is like after and before the program or (b) what one place is like with the program and another is without it.

oThus, you cannot be sure that the effects you observe are not due to non-program differences over time or across places.


The With-Without Principle

The two ways to solve this problem are:

o random assignment

o statistical control

Random assignment insures that differences across time and place are

not correlated with program.

Statistical controls can account for observable (and some

unobservable!) differences across place or time.


Approaches to Program Evaluation

Random assignment is the preferred method in most cases.

oIt provides results that are intuitively compelling and scientifically sound.

oIf you believe in cutting costs, become an advocate for evaluation using

random assignment!


Random Assignment

Random assignment has been used to study (among other things):

o Welfare-to-work programso Unemployment insuranceo Job trainingo Income maintenanceo Housing assistanceo Electricity pricingo Education (e.g. Charter Schools)o Early childhood developmento Criminal justice policyo Child health and nutrition


Random Assignment Examples

Random assignment is not always feasible.

The best statistical studies:

o Must have extensive data to ensure that differences aren’t due to

unobservable factors.

o Must have comparable treatment and control groups based on

observable factors, which often requires new “matching”

methods.

o May have multiple observations over time so they can “difference

out” unobservable factors.


Statistical Studies

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.


Competition and Costs

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.


Provision vs. Production

Production Arrangements Include:

o Contracting out to a private firm

o Contracting out to another government agency

o Outsourcing, i.e. purchasing from a private company

o Use of vouchers to finance private production

o Intergovernmental cooperation (to gain economies of scale)


Production Examples

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.


Competition vs. Privatization

Consider the following ways to move away from delivery by a single public agency:

Charter SchoolsPublic School Vouchers

Private Electric Company

No-bid Contract

PrivatePublic

Public AgencyMonopoly

Competition Private School Vouchers

Bids & Contract


Alternatives to Public Delivery by One Agency

Although competition is likely to cut costs, the impact of privatization on

costs is not so clear:

o Private firms are probably more likely to innovate because it boosts

their profits.

o But private firms are also more likely to cut corners or to neglect

social concerns—if their contract allows—in order to boost profits.


The Benefits and Costs of Privatization

Issue 3: The Need for a Clear Definition of Performance

The key to harnessing competition and private firms’ desire for profits

is to write a contract that:

o Specifies performance standards

o Provides clear incentives to meet those standards


Defining Performance

Contracting out to private firms can work well if:

o The relevant market is competitive and bidding is possible

o The performance objectives can be clearly specified in the contract

o A firm’s performance can be monitored

o Financial rewards and/or penalties can be written into the contract, too.


The Requirements for Successful Privatization

Big Problem Number 1:

Cost savings are almost impossible to document.

Cost savings only exist when full costs are lower, holding performance constant.

o But many costs are hidden.

o And performance usually cannot be measured.

Beware of cost-savings claims!


Documenting Cost Savings

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!


The Role of Politics

lecture 5 public sector costs: policy state and local public finance professor yinger spring 2016

Documents