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Paul Andrisani and Simon Hakim

Center for Competitive Government

Richard J. Fox School of Business and Management
Temple University

Privatization of public services to reduce cost and improve quality has a long history. Peter Drucker, the Austrian born management professor, was the first to suggest contracting out of local services to private companies. Indeed many municipal services were already contracted out by 1980 in Great Britain. But the most significant drive for privatization in Great Britain, which signaled the way to the rest of the world, came about with the election of Margaret Thatcher in 1979. In the following decade a host of state owned enterprises were privatized including British Petroleum, British Aerospace, Jaguar, Rolls Royce, National Freight Corp., Cable and Wireless, British Airways, British Gas, British Telecom, several water and electric utilities. In addition, public housing was sold to the residents and compulsory competitive bidding of local services was initiated.

By the late 1980’s, Mexico, Brazil, Chile, and Argentina elected presidents who adopted privatization initiatives. But the trend toward privatization was not confined to western countries. The collapse of Communism in the Soviet Bloc prompted the sale of many state owned enterprises as well as other forms of privatization. Even earlier, China in 1978 allowed private farming and later private sector manufacturing and retail operations. And Vietnam allowed private businesses and Cuba allowed homes to be sold to their tenants.

Privatization of government activities in the world reached a record high of $89 billion by 1996. Within a year this mark was surpassed with an even more impressive record of $160 billion in 1997. A great deal of this recent activity was attributable to the sale of state owned assets in telecommunications in Western Europe (Reason, 1998).

In the U.S., privatization efforts have been more limited since industries such as communications and airlines were already private. The focus of privatization efforts on the state level has mainly involved the contracting out of services. According to a recent survey, approximately eighty percent of state level privatization efforts involved contracting out of services, six percent involved private sector grants and subsidies, and four percent involved public-private partnerships (Keon and Jasper, 1998). The leaders in these initiatives were Florida, Colorado, California, Michigan, Maryland, and Iowa.

Contracting out involves almost all services delivered by government. Grants and subsidies occur typically, however, in social services, health care, mental health and retardation, and transportation agencies, while public-private partnerships tend to be concentrated in corrections, health care, and social and mental health services.

In the sections to follow in this introductory chapter, we focus on a number of overview issues. First, we outline general criteria for the appropriate intervention of government in the marketplace. Second, we then discuss the forms such intervention may take. Government intervention does not mean, for example, that government necessarily needs to produce and or supply the service at issue. For instance, while national defense is clearly the responsibility of government, the production of weapons is typically delivered by private companies and not by government. This allows competition to enhance efficiency. The objective should be to expose as many government services as possible to competition in order to improve the efficiency of production of products and services that government is responsible for delivering.

Third, we then discuss the stages in implementation of privatization efforts, and the likely conditions for success. Special attention is placed on institutional changes, activity based costing (ABC), managed competition, and obstacles preventing privatization. Fourth, we then summarize briefly the focus of each of the sections to the remainder of the book, and the chapters included within each section.

Criteria for Government Intervention

Adam Smith, the famous economist who wrote Wealth of Nations in 1776, has said practically everything that is important in economics. According to Smith and the conventional economic theory that is his legacy, there are four conditions for government intervention in the marketplace: (1) pure public goods, (2) externalities, (3) natural monopolies, and (4) products or services with zero marginal cost. At least one condition must be met in order to justify government intervention. Where one or more conditions are met, the question then becomes an issue of the nature and degree of intervention. The objective always is to maintain the minimum level of government production and provision of service while exposing as many industry segments as possible to competition. Absent market failures, competition will always yield efficient production and supply of any good or service.

Pure Public Goods

In the first case, a pure public good is defined as a good or service that yields benefits to all constituents, even those unwilling to pay. Accordingly, such goods will not be provided under pure market conditions. By its nature, government provides the entire output for each person. However, no one has sufficient incentive to provide the pure public good and the only way to ensure its provision is for government to mandate it. This is because individuals have a strong incentive to become “free riders,” that is to enjoy the full benefit of the public good without sharing any of the cost. It is sometimes either impossible or prohibitively costly to exclude anyone from consuming the good or to assess user fees to those who do. A classic example is national defense. While almost everyone agrees that a nation needs to spend substantially in order to defend itself against aggression, and while every citizen enjoys the full benefit of national defense, no one or no group has sufficient incentive to provide adequately for the entire public defense of all. This is because they would be absorbing all the cost of providing the benefit for themselves as well as for all others, including those unwilling to voluntarily absorb any of the costs of their own defense. With pure public goods, there are high social returns relative to the private returns, and high social costs relative to the private costs. Government therefore must require each citizen to share the costs of pure public goods and, in the process, prevent free riders from reaping the benefits without contributing to cover the costs. Analogously, state and local governments have the responsibility of protecting public safety and preserving and enhancing the infrastructure and environment. However, some aspects of each of these responsibilities can clearly be provided by the private sector, enhancing the degree to which competition can promote greater efficiency in the delivery of these public goods and services. Policing, for example, has several functions that can be provided privately, such as in the dispatching of officers and the towing of vehicles that block ingress and egress to highways. These services clearly can be contracted out, and, because of competitive pressures, be provided at lower costs and with increased efficiency. While the production of pure public goods may require government intervention, this does not imply that government must produce or supply the service. The production of military equipment, for example, is contracted out while government provides the supply of national security. Still further, government often provides other goods than those that are pure public. Considering two important factors that exist in a market -- the degree of provider rivalry and exclusion of “free riders– Table 1 shows the continuum from pure private goods to pure public goods. Table 1 Dichotomy of Goods and Services

Exclusive Non-exclusive Rivalry Pure private Common pool Non-rivalry Club Pure public

Examples of "club goods" are swimming pools, toll roads, and country clubs, where user fees, membership or tolls can restrict consumption. Unless the private sector inequitably distributes such services, such as in the case of training for the structurally unemployed or swimming pools in inner cities, there is no need for the public sector to provide club goods. Even where inequities in the provision of such services exist, however, government intervention into the delivery of club goods may often be limited to the contracting out for such services to private providers or the provision of vouchers for use in the private sector. There is limited, if any need for the provision and/or delivery of club goods by the public sector. Examples of “common pool goods” include public domain ponds, rivers, etc., with seasonally limited quantities of fish. While government intervention may become necessary to control the amount of fish that are caught, here too the regulation may be contracted out rather than provided by the public sector itself.

Externalities In the second case, externalities may be defined as by-products of activities that escape the price mechanism, and may be of a positive or negative nature. The government's role is to internalize externalities such that their price is included in the price of the by-products rather than being subsidized or wasted as a free good. In the absence of government intervention, a negative externality is normally over supplied and must be discouraged while a positive externality merits increased production. If the transaction costs associated with such government activity exceed the benefits or costs realized, then social welfare requires no governmental intervention. Externalities can result from production or consumption. An example of a negative externality in production is air or water pollution resulting from a factory that manufactures clothing. Emitted pollution causes adverse health effects and property damage to nearby residences of the facility. If these adverse effects are not charged then the price of the manufactured clothes do not include the cost of the pollution. The product which generates a negative externality is over supplied in the market place. Government can intervene by taxing the output by the cost of the pollution. This will result in the market price of the product and borne by both the producers and the consumers of the product that caused the negative externality. The tax receipts might well be used to compensate those suffering from the pollution. The lower the price elasticity of demand for the product, the greater the share the consumers will pay of the tax. Provision of education is an example of a situation where positive externalities exist. Private benefits include enhancing self-sufficiency by increasing earnings capacity. Public benefits include tax paying capacity, good citizenship, and decreasing dependency on government for services and transfer payments. Government provision of education serves both to increase private output of education and its positive externalities. Government involvement in education is justified both in terms of efficiency and equity. Positive externalities suggest that government should encourage expansion of the production of education to levels produced under competitive market conditions in order to attain society’s desired level of service. From an equity viewpoint, government involvement is desirable to promote upward economic mobility. Again, government involvement in education does not require the provision of its own supply of educational or training services. Rather, the provision of vouchers is preferable because by subjecting alternative service providers to the rigors of competition, consumers gain freedom of choice, lower costs and greater quality. Another example of positive externalities is population-wide vaccination against polio. Again, this is a case of a mixed (or “quasi-public”) good where private benefits and external positive externalities exist. Population –wide vaccinations will not be conducted unless financed by government. The actual supply of vaccine and its provision may be contracted out in a competitive process rather than provided by government.

Natural Monopoly In the third case, a natural monopoly is defined as a single provider in the market. The absence of competition may result from significant economies of scale, technological superiorities, and/or asymmetric information that over some period of time eliminated all competitors. Government intervenes in regulating monopolists in order to prevent them from exercising their pricing power. Entry of new competitors to increase supply and return prices to competitive levels will not normally be feasible, since barriers to entry are normally quite difficult to overcome in the face of monopoly situations. Government intervention in this case should be in the form of regulating prices and enabling competition, since private supply is preferable to government supply. Examples include all local utilities – e.g., telephone, electricity, gas, water supply, etc. New technology increases the availability of close substitutes and should allow for the eventual elimination of regulation. Indeed the 1996 Telecommunication Law eliminated all federal and state regulation of the telephone industry.

Zero Marginal Cost The fourth case that requires government intervention is where marginal costs are zero and remain constant. Non-competitive providers, however, are likely to charge higher prices to the point where marginal revenue equals marginal cost. As an example, consider the case of a road without any traffic congestion. Additional riders cause no increased cost to the road provider or to other drivers. Hence, additional traffic can be accommodated and offered free of charge. A private provider, however, will likely charge a fee unless the price elasticity of demand equals one (and total revenue is maximized) or unless profit is maximized without a fee. This results in reduced output relative to the socially optimal quantity. These criteria establish important guidelines as to the types of services government needs to provide when efficiency from a societal viewpoint is at issue. For example, tennis courts provide service only to some constituents and entail few, if any, positive externalities, are also provided privately and therefore require no public intervention. On the other hand, providing municipal police is the responsibility of government due to pure public good attributes of some of its services. However, such responsibility does not necessarily require government to monopolize the supply of the service. Indeed, General Washington employed “Pinkertons” from a private security company that still exists, as private spies against the British during the American Revolution.

Additional criteria for government intervention can be found in Wilson (1996, A, B). In the view of former governor Wilson, a governmental agency should provide a service only if it directly supports its central mission. If the service is a core responsibility and the agency can provide it with the best quality and cost efficiency, then it should be provided. Each governmental agency should sort its activities into three categories in order to decide the fate of the activities. It is essential that individual activities, rather than aggregate agency activities, be investigated and that each of the three possible alternatives be carefully considered with all costs weighed against the benefits.

In the first alternative, the agency should consider whether to “Retain” the service. Direct control of activities characterized as pure public goods, such as public health, environmental quality, safety, collection and use of restricted data are likely to be considered candidates for retention. Nonetheless, even though control or responsibility must lie with government, the actual production of the service or parts of it can be contracted out to the private sector if the latter can do so cost effectively. In the event the activity will be retained, the agency should consider whether the activity is a candidate to “improve.” Restructuring and consolidating operations to improve efficiency of core activities are obvious considerations here.

In the second alternative, if an activity supports the central mission of the agency but is not a core activity, and where it can be provided in a more cost effective manner by another government agency or private sector firm, then “outsourcing” or “contracting out” should be carefully considered. Usually it is a service that is provided on a larger scale with significant economies of scale, or as a by-product of another firm or agency that can provide the service at lower marginal cost (economies of scope). Examples include central records management, computer services, food services, security, janitorial services, administration of tests, property management, travel and medical services.

Basically, all “back office” operations from payroll to data entry should be considered as candidates for outsourcing or contracting out. Many large private sector firms such as the DuPont Company have restructured in-house production of their main core activities, and have decided to outsource many functions that could be provided at lower cost and greater efficiency by others. In the case of DuPont, this led to a $4 billion outsourcing to Anderson Consulting and others of their management information systems. Indeed, the outsourcing of management information systems may be the next great wave of outsourcing in the public sector, as outsourcing firms that have successfully penetrated the private sector begin to penetrate the public sector as well.

Outsourcing these and other tangible activities, and thereby reaping economies of scale and scope, may also avoid numerous labor problems by reducing the number of direct employees. Indeed some of the apparent reduction in U. S. manufacturing employment is the result of outsourcing some activities previously done in-house. A data entry employee of a manufacturing firm is counted in manufacturing. With outsourcing, however, the employee becomes a service sector employee. Employees, in other words, may not necessarily lose their jobs in this scenario but simply switch employers as is often the case with asset downsizing in the private sector.

The third alternative is to “transfer” an activity that governmental agencies have accumulated over time but which do not directly support their mission or provide services or functions that cannot be satisfied at lower cost and greater efficiency by private sector firms. Governmental agencies should consider eliminating responsibilities for such activities. President Reagan, early in his first term, suggested that many welfare programs do not support the central mission of the federal government and could be transferred to non-profit organizations such as the Red Cross. State and local governments fund and operate cultural and recreational facilities that could be supported through donations from the private sector and delivery through non-profit entities. On the state and local levels, for example, governmental agencies might relinquish to community groups their responsibility for the management of organized sports activities such as tennis and golf facilities.

Dichotomy of Privatization

Now that we know the characteristics of services that require public intervention, the other side of the coin becomes clear. In all cases where public intervention is not necessary, the services can be shifted to the private sector. A point of clarification, however, is in order. The issue is not public versus private sector superiority, but rather it is the superiority of competition versus monopoly. For this reason many claim, and justifiably so, that privatization is the wrong term. There are no simple reasons why well established government agencies should not be allowed to compete with private firms to provide services so long as the delivery of such services are warranted on cost and quality criteria. Indeed, following the Indianapolis experience under Mayor Goldsmith to be discussed in this volume, the term “managed competition” was coined and prevailed. The following are the most prevalent forms of privatization (Savas , 1998):

1. Contracting out

Government contracts all or a part of a public service delivery to private firms. Examples include trash collection, waste water treatment, water supply, building repair and maintenance, human services delivery, prisons, and operation of public transportation. Government maintains control of performance through monitoring compliance with contractual requirements and commitments. Of all forms of privatization by state governments, 78 percent is contracting out. In 1998, one in twenty inmates is in a for-profit prison. More than one in eight beds in community hospitals is privately run under contract with government. Seventy-three percent of all local governments use private janitorial services, and 54 percent use private garbage collection. Contracting out by local governments has apparently accelerated in the 1990s. In 1987 only 52 percent contracted out janitorial and 30 percent garbage (See Wessel and Harwood, 1998).

Conditions for the selection of service to be contracted out can be summarized briefly as follows:

1. Clear and precise definition of expected output(s) with measurement of quantity and quality of service. Thus, the contract should clearly state the terms that the contractor needs to satisfy. Where output cannot be easily measured, privatization is unlikely to be successful since firms will probably reduce the quality or quantity of services to increase profit. This difficulty also occurred in the regulation field where, for example, firms could reduce quality in ways that are difficult to ascertain. An example would be a slight increase in the probability of a blocked telephone call at the busy hour. 2. Competitive environment with multiple providers. Mayor Goldsmith of Indianapolis conducted the “Yellow Pages” test in order to identify candidate services for contracting out. If enough private providers exist for a public service to be competitively bid, then it could be contracted out. In fact, since the market may be substantially larger than the local area, offering a government service for competitive bidding might attract firms from some distance. 3. Monitoring by government should be of low cost. Savings from contracting out should be higher than the contract bidding and monitoring (enforcement) costs. 4. Government must be prepared to pick up the delivery of service if the contractor fails before the contract expires. 5. Explicit definition of the population and/or the geographic area to be served. 6. Choose services which entail low probability of changing conditions which will affect costs. 7. Government monitoring should be effective but should not be so stringent as to smother the contractor.

Contracting out of trash collection or waste water treatment satisfies the above conditions. The output is well defined and can be easily measured. A political district can be easily defined for the delivery of service. Government monitoring for possible violation of contracts is easily conducted and easily proved when violations are found. It is of no surprise that the majority of such efforts proved successful.

On the other hand, a private company was contracted to manage the entire school districts of Baltimore, Maryland, and Stanford, Connecticut. The outputs of education are not well defined, and are difficult to measure. Monitoring and enforcement of the contract were very intense, expensive, and “smothered” the contractor. It was not long before the company failed and the school board had to take over the schools. It is obvious that it is difficult to specify quality of education in a contract, and close monitoring is required. The contracting out of schools to a private monopoly violates our criteria, is as objectionable as a public monopoly, and is likely to fail.

Introduction of competition is better achieved through school choice or a voucher system. In the case of prison food provision, as another example, contractors could reduce the quality of the food so that specification and monitoring would be moderately difficult, but not sufficiently so to prevent privatization.

2. Deregulation

Government removes its regulation in favor of self or no regulation of the service. Regulation was sometimes initially imposed when natural monopoly existed over a basic, widely used service. Characteristics commonly associated with such regulation include a capital intensive, privately owned industry with significant economies of scale that could eliminate competition. In order to prevent the monopoly from exercising its price control for a service with low price elasticity, the state chose to regulate the industry in order to protect the consumers. Examples include water, electric utilities, and telephone services. Over time, however, with improved technology and economies of product bundling, competition became possible and the State removed its regulation.

It is interesting to note that many of these services in other countries were State Owned Enterprises (SOE) and as such have been sold to the private sector. Further, much regulation occurred in such industries as airlines and trucking which did not exhibit the natural monopoly requirements. They were regulated for reasons other than the protection of consumers. Indeed, economists have long suggested that regulation was sought on occasion by industries in order to reduce competition and to protect producers from consumers. Accordingly, de-regulating such industries was quite feasible.

Also, during the era of regulation, internal subsidization of services occurred. Some telephone users, for example, received services below the costs of providing it. Regulation occurred on occasion to provide benefits to some at the expense of others, which results in cross-subsidization. One effect of deregulation was to eliminate such subsidies as well as to increase competition and provide better and cheaper services to consumers. However, deregulation may not have yielded as much competition as intended. The deregulation of the telecommunications industry in 1996, for instance, led to accelerated mergers among firms comprising the Regional Bell Operating Companies or firms with complementary services. Similarly, mergers among airlines have led to some airlines dominating particular cities. Nevertheless, the impact of deregulation in airlines has, on balance, increased competition, lowered costs to consumers, and increased the overall volume of traffic in the industry.

3. Franchising

Government awards an exclusive (monopoly) or non-exclusive right to a firm to provide a service in a restricted geographical area. At times it awards a temporary monopoly with certain safeguards. Again, it is often a service that is characterized as capital intensive with significant economies of scale. The service may require a large number of subscribers in a limited geographical area in order to be profitable, or the physical area or resource may be quite limited.

There are two typical forms of government franchising: (1) use of the public domain by a private firm to conduct commercial activities, and (2) use of a government owned property by a private lessee. Examples of type 1 are broadcasting and cable TV, and an example of type 2 is service stations in rest areas of limited access highways. Improved technology enables increased competition in type 1 franchising cases. For example, cable TV now competes with other forms of transmission like satellite or microwave. The introduction of Broadband technology (ISDN-- fiber optic use) where expands band width means that telephone companies are now poised to offer cable TV service and cable TV firms are able to expand into telephone and Internet services.

SR91 in southern California is an example of a temporary monopoly where the private company was franchised to build and operate a toll road for a preset period of time. The development of increased competition as described above should allow for a reduction of governmental franchises and enable markets to operate more efficiently.

4. Grants/Subsidies

A firm or an individual does work which is financed by government. Grants are awarded to promote the arts, for low income housing, for research, and to encourage private businesses to grow within enterprise zones. Typically, contracts are quite specific to fulfill a task, while grants and subsidies usually leave more discretion to the recipients than contracts.

5. Vouchers

This approach directly subsidizes consumers rather than the suppliers of a service. Vouchers are currently used to provide food, education, health, and housing to those who qualify. In this case, the recipients buy the products or services in the market place using the governmentally provided or subsidized vouchers. This form of governmental intervention is preferable to contracting or franchising directly with suppliers of these services because in the latter suppliers often possess monopoly or significant pricing power. As such, if they are the direct recipients of the voucher, as in the case of contracting out or franchising, suppliers have no incentive to improve performance or increase competition that might benefit consumers who are a captive market and cannot switch to another supplier. Competition among private suppliers is continuous when recipients enjoy their freedom of choice using vouchers. This method is preferred to the time limited competition of contracting out. In the latter case, competition is restricted to the period of the bidding.

With vouchers, suppliers must compete in order to gain the business of consumers who become empowered by the vouchers. Vouchers also mean that new entrants to the market might develop to challenge governmental monopolies and expand competition. For example, in the case of vouchers for education, students and their parents can shop around for the school that best meets their preferences instead of being locked into a single school as the sole supplier of educational services. As a result of the increased competition, new schools come into existence to compete with existing schools for the educational dollars being spent.

6. Service shedding

The government gives up responsibility for an activity while working with a private organization that takes over the responsibility for provision of the service. Such private organizations are usually but not always non-profit firms. As already pointed out, President Reagan argued that many social activities of government can and some day will be provided by non-profit organizations staffed mainly with volunteers.

A local example is youth recreational programs. In some major cities, youth programs are managed in the city parks by professional instructors and off-duty teachers. Many local governments shed these services and responsibilities and allowed them to be delivered by local non-profit organizations where parents and volunteers manage the operations. Municipalities make the fields and facilities available to the groups who take care of the grounds, make capital improvements, and manage the activities. Another example of shedding a service, but to a for-profit firm, is the giving up of internal fleet maintenance to a company that acquires, leases, and maintains vehicles for a governmental entity.

7. Sale of Assets

Sale of assets is common in countries other than the U.S. where a far greater share of business ventures typically were and are still owned and managed by government. In the former Soviet Union, for instance, the extent of the sale of assets is reflected in the fact that private sector contribution to GDP in 1998 is estimated to exceed 50 percent in 19 of the 26 states that once formed the Soviet empire compared with only 1 to 4 percent in 1980. This is a result of both sale and transfer of business enterprises to the rapidly emerging private sectors in these states. Another example is Great Britain, where British Airways, British Telecom, British airports, British Gas, Rolls Royce, and Jaguar were sold to private interests.

In the U.S., privatization appears to be proceeding less rapidly, with the share of GDP derived from private sources rising from 79.4 percent in 1980 to only 82.0 percent in 1998. The less rapid rise in privatization in the U.S., however, is doubtless due to the already greater extent of the private sector in 1980. Examples of privatization include asset sales of parking lots and apartments to the private residents.

8. Public-private partnership

This is a joint venture where the government joins forces with business for a major development such as a new shopping center. The objective is to provide impetus for a development that would not materialize unless government is involved. Once such a “growth pole” is initiated, market forces continue it. Local funds and joint municipal efforts were made to redevelop the Head House Square area in Philadelphia. The success of the project led to continued real estate development by the private sector south into Queen’s Village and west towards Broad Street with limited municipal involvement. The extent of the initial effort would not have occurred without municipal participation. Government can also join businesses in marketing programs for tourism and business retention.

Public-private partnerships are most common in infrastructure. The following nine alternatives are currently being practiced throughout the country (Payson and Steckler, 1996):

1. Government owns a facility that is operated and maintained by a private company. 2. A private company designs, contracts, operates, and maintains a facility where the investment is made or financed by government. The private partner's risk exposure is limited. 3. A private company finances, develops, operates, and maintains an addition to an existing public facility. The private partner can operate both parts for a specific period of time or until the initial investment and a reasonable return on the investment are recovered. 4. The private company leases for a long term, and develops, operates, and improves a publicly owned facility. 5. An existing public facility is transferred to a private company for renovations and operation for a specific period of time or until the investment and return on the investment are recovered. An example is a deteriorated bridge that requires repair and maintenance, but the public agency lacks the necessary resources. 6. Buy-Build-Operate (BBO) is a practice that is similar to the previous model except that ownership is reserved for the private company. The agreement allows the government to exercise control over safety, environmental effects, pricing, and quality of service. 7. Build-Transfer-Operate (BTO) is a practice wherein a private company finances and builds the facility and then transfers it to the government agency. The latter then leases it to the private firm which operates it. The difference between this model and the pervious one is that in this case the governmental entity legally owns the facility. By leasing from government, the private firm avoids a number of legal, regulatory and tort liability problems. The 91 Express Lanes in California are an example of this type of public-private partnership. 8. Build-Operate-Transfer (BOT) is the case where the private firm finances, builds, owns, and operates a facility for a specific period of time or until the investment and a return on the investment are recovered. Ownership is then transferred to government. This is essentially the model for the Dulles Greenway Toll Road in Virginia. 9. Build-Own-Operate (BOO) is the case where a private firm finances, builds, owns, and operates a facility, which gives the firm the incentive to further invest in the facility due to its unlimited (in terms of time) ownership. The private firm may, however, be subject to price and quality regulations.

Managed competition

In this model, public employees who currently provide an existing service that is under consideration for contracting out are allowed to bid against private providers. Employees are provided with training on how to compute costs and complete procurement documents. This model was initiated by Mayor Goldsmith of Indianapolis and is aimed at achieving efficient provision of service and competition between public and private sector providers. Existing public service providers entail experience and knowledge about the nature of the service; however, they often lack the market pressures to produce it in a cost efficient manner. On a practical level, since managed competition preserves employment of government employees, it serves to diffuse the objections of labor unions that represent these employees.

Managed competition is considered by some to be unfair towards private sector competitors since government agencies are typically exempt from property and sales taxes and in many cases need not cover rental space costs. By exposing public employees to market competition, however, managed competition leads to lower costs and/or higher quality.

On its own, managed competition may not be sufficient to improve long term efficiency in the delivery of public services. While it may help induce public sector workers and managers to find ways to improve their performance in the short run in order to preserve their existing jobs, it is essential that long term incentives be initiated in order for long term improvement in service delivery to occur.

Subjecting public employees to frequent competition with outside firms may be a solution. Personal rewards are often the basis for long term continuous efforts to improve efficient service provision. Public workers should be provided with contractual incentives such as bonuses and other permanent salary based merit awards to encourage continuous efforts.

Criteria for success

The General Accounting Office (GAO), an arm of Congress, conducted a 1997 literature review and obtained the views of an expert panel on the key success factors for privatizations. The GAO reviewed a study of six state and local governments that are leaders in privatization efforts to learn more about the keys to success. The following are the six most important keys to success that were identified:

1. Having committed political leaders to champion the initiatives, e.g., a Governor, Mayor, or several legislators who cooperate in the effort. The GAO study added that flexibility is necessary in adjusting strategies when problems arise in the implementation phase. Maintenance of momentum is also required. 2. Establishing an organizational and analytical structure to implement the initiatives. A central office for the government can help in analyzing the candidates for privatization and assist agencies in implementing the effort. The states of Virginia, Illinois, Massachusetts, and Georgia established effective commissions that initiated and advised on these matters. 3. Enacting legislative changes and/or reducing available resources to encourage greater exposure to competition. These changes are aimed at signaling managers and employees that the restructuring efforts are indeed serious. 4. Developing reliable activity-based cost accounting to determine performance of the government agency and to enable evaluation of the feasibility of private sector provision of services. Indianapolis was first in successfully introducing Activity Base Costing (ABC). This enabled precise and complete cost data to become available on individual activities. ABC is distinct from the traditional agency-wide accounting system that usually renders impossible the effective evaluation of alternative service provision by private sector firms. 5. Involving employees and labor unions in the privatization process. Lack of involvement of unions in Massachusetts led them to block the efforts. Union concerns and political influence led to legislation that made future privatization efforts more difficult. Indianapolis was successful because employees were involved from an early stage. Workers were trained in new tools such as ABC accounting and employees were allowed to compete. Further, front line workers were given decision making power, some supervisory jobs were eliminated, training was provided to workers responding to the RFP, and a safety net established for displaced workers. In this regard, workers' concerns about losing their jobs appear unfounded. A 1989 National Commission on Employment Policy (NCEP) survey showed that 24 percent of workers in services that were contracted out were transferred to other government jobs, 58 percent went to work for the private contractor, 7 percent retired, and only 7 percent were laid off. An Illinois report (Johnson and Walzer, 1996) provided similar findings: of all services that were contracted out, two thirds of the relevant employees were unaffected and only 3 percent were laid off. Less skilled public sector employees and those with less seniority, of course, doubtless face greater risks of losing their jobs and greater difficulty in finding commensurate reemployment following job loss.

Two options have been widely used to mitigate against employee and union resistance to privatization: (1) a guaranteed right to interview with private contractors, and (2) a right of first refusal with private contractors who take over government service delivery. For example, in the correctional services field, it is common for private contractors to hire the public sector guards in order to maintain continuity of service. It must be emphasized, however, that state laws typically do not require private contractors who hire public sector workers to maintain their wages and benefit packages.

In addition to job security, another issue is what happens to wages after a privatization. An Illinois report states that workers whose jobs were contracted out in Chicago experienced average wage losses of from 25 to 49 percent in the period 1989 through 1995 (Chicago Institute, 1997), which is indeed a substantial wage loss. Government needs to help the public sector work force make the transition to a competitive environment. Such assistance surely includes training employees and providing a safety net for those displaced. Lack of such efforts may yield political obstacles in implementing the restructuring efforts. However, the process of assisting employees in becoming competitive should not create asymmetric information where private companies are hindered by being less informed than the public employees about the nature of the service and the requirements for winning the contract.

6. When privatization or a competitive government structure is established, a monitoring body should be established to assure compliance with the designated contractual terms. This monitoring agency should ensure that the required performance level is maintained by the contractor but, at the same time, it should not unnecessarily hinder the contractor's operations.

Stages of Implementation

A governmental entity frequently determines the need to restructure the conduct of a particular service but lacks a decision making process to evaluate what is the preferred form of delivery and how to implement the plan (Fryklund et al, 1997; Wilson, 1996 (B)). The following stages are suggested for government agencies considering privatizations:

1. Define the mission and consequently the essential responsibilities. 2. Determine all major activities and whether each activity is integral to accomplish the mission. 3. Determine whether the activity supports another agency mission or can be transferred to the private sector. 4. Develop performance, cost, and quality measures for all core activities. Compare them with similar services of other government agencies and the private sector. It is essential to change the accounting system to become activity based. The cost of an activity to the agency should include direct and indirect costs imposed upon other branches of the government and costs imposed on the particular agency’s hierarchy for performing the service. Contracting out costs should include the contract cost, monitoring costs, and the transaction costs of shifting to a private provider. An appropriate discount factor may have to be applied if the benefits and costs do not all occur in the same time period. 5. Benchmark the service with other public and private organizations to determine whether changes are required in the delivery of the service. 6. Determine whether direct control is necessary and whether the agency has a comparative advantage in performing the activity in-house. Some services may need to be performed by government even if at higher cost in order to directly control the process. Examples include use of police power, the use of restricted data, and other matters which imminently affect public welfare. 7. Contract out all activities that are not performed at comparative cost in the private sector. All government services that are provided for in the private sector are candidates for contracting out. As previously mentioned, Mayor Goldsmith of Indianapolis adopted a “Yellow Pages” test where all services that have private providers become candidates for contracting out. 8. Determine whether part of a service can be contracted out. For example, even though public order is essentially a pure public good, some police and fire investigational activities and laboratory work can be conducted by private companies rather than by the public sector if greater efficiencies can be gained without meaningful loss of control.

Institutional Changes

The above activities require at least two institutional changes:

1. Creating a permanent commission that assists in the conversion of the accounting system to an ABC (activity based costing) system, determines candidates for privatization, and assists agencies in implementing the changes. The commission should collect ideas from government employees, prepare material for the legislative and executive bodies, help with the legal issues of preparing the bids and contracts, and prepare agencies for their monitoring duties. 2. Creating a labor/management council to oversee the process wherein government agency prepares to compete with private firms in the provision of public services. The council should be composed of managers, supervisors, and union and workers' representatives, and should assist workers in reorganizing their efforts, adopting new technology, preparing bidding materials, and preparing a safety net for displaced workers.

Activity Based Costing

The ABC method of accounting is necessary in order to determine whether real savings would indeed occur if the operation of a government service is shifted to a private provider (Wilson, 1996B). The method currently is being used in a number of municipalities including Indianapolis, Milwaukee, Phoenix, and Summerdale, California. When calculating costs of an activity, all costs should be fully considered, including direct and indirect costs plus a proportional allocated share of organizational overhead. Indirect costs include personnel, legal, purchasing, interest, pension, and capital costs of facilities and equipment.

These costs (e.g., cost per pothole repaired) are usually reported outside the particular agency (e.g., under the public works umbrella) and are not directly related to the activity that might be contracted out (pothole repairs). Office supplies are purchased centrally and some are used in the production or service provision of the activity at issue and, as such, their costs must be included. Other indirect cost items that are often ignored in the calculation of in-house costs are rent and warehousing of material when the offices or warehouses are owned by government. Imputed costs must be incorporated for the activity. Similarly, overhead costs must be considered that accrue indirectly to the agency and to other parts of the government. For example, part of the salary of the director of the public works department is properly attributed to the pothole repair.

Contracting costs are not limited to the amount specified in the contract with the private provider. These costs should also incorporate administration and avoidable costs minus new revenues. Administration costs are all costs included from the time that a decision is made to contract out the service until it is fully executed and the contract expires. Included are costs of procurement, contract negotiations and award, possible disputes, invoicing, and monitoring and evaluation. Avoidable costs are costs that are avoided if the service is contracted out, and usually exist only in the long run. A major category here is the anticipated reduction in payroll due to the reduction in the size of the government labor force. As mentioned earlier, an appropriate discount rate may have to be used if all costs and/or benefits do not occur in the same time period.

Another issue is how to calculate certain costs imposed on the government, such as fully allocated and contracting costs. The two options are marginal costs or total allocated costs. If the agency is operating in an excess capacity situation, a marginal cost calculation is preferred since further service delivery involves only additional variable costs. Otherwise, a fully allocated calculation is in order since additional fixed and variable costs must be incurred to increase service delivery.

Clearly, initial calculations are of an average cost variety— i.e., on the basis of cost per unit of activity. Discretion is needed in every case in deciding upon the preferred method of calculation. When a particular service is insignificant in magnitude compared to the many supplied by the same provider then indeed the real opportunity cost needs to be determined. For example, a dispatcher’s time at work is not changed when a particular service (out of many) is taken away. Thus, no savings occur when the activity is withdrawn and contracted out.

ABC accounting is essential to determine whether indeed a service should be contracted out. These costs are also important for benchmarking against other agencies that provide similar services. For a service that enjoys significant economies of scale, a small city normally would prefer to contract out services to adjacent large cities (Mehay and Gonzalez, 1992) or to a contractor that already serves other localities in the region. Without comparative costs of other jurisdictions and private providers, rational business decisions cannot be made about contracting out from the public to the private sector.

In Indianapolis, ABC calculations showed that the costs of sealing cracks in public roads were reduced from $1,200 to $738 per lane-mile of public road by contracting out. The lower costs of the private contractor per lane-mile of public road repaired were further subdivided by category as follows: labor costs of $353, material costs of $62, equipment costs of $82, vehicle costs of $54, and overhead costs of $186.

Managed Competition

This situation exists when a public agency competes with private firms for the provision of a public service under a controlled or managed process that clearly defines the steps to be followed and the roles of all participants (Colorado Commission, 1998). Usually, government agencies help their workers learn how to improve their performance and complete the required procurement documentation when these public employees are expected to compete with private contractors for the delivery of public services.

Thus far our discussion has indicated that government agencies have often been successful in keeping services that were exposed to private competition. In some cases, workers retained services by bidding lower prices. The exposure to competition presumably increased workers’ efficiency in providing the service and facilitated the introduction of new technology. Managed competition often leads to greater decision making powers of “production line” workers, elimination of excessive layers of middle management, greater involvement of workers in trying to improve the delivery of services, the encouragement of entrepreneurial activity, and the delivery of public services in a customer-friendly fashion. The most important accomplishment, however, even though it remains hidden, is that managed competition generally diffuses union objections and possible interruptions to the contracting out of government services.

In Indianapolis, public employees won the bulk of the contracts put out for bidding. These include in-house provision of many services that in other localities are provided by private companies. An example is refuse collection where worker productivity doubled when routes were redesigned, resulting in annual savings of $15 million. As another example, city fleet service workers outbid three private companies, and as a result the employees involved earned $2,200 in performance bonuses.

Managed competition in Phoenix also proved successful. The city introduced competitive bidding in 13 service areas such as ambulance service, data entry, landscape maintenance, and public defender tasks. Overall, 22 contracts remained with government and 34 were privatized.

Interestingly, managed competition induced workers to bid for similar services in other jurisdictions and could possibly allow public sector workers compete on similar private projects. While job security is always a paramount concern, it is important that workers not only keep their jobs but also share in the savings by receiving, for example, end of year bonuses. Gainsharing, as it is called, stimulates greater efforts toward improved performance and efficiency in the delivery of public services.

It is also important to recognize that public workers often enjoy several advantages in comparison to private firms that bid for the same activities. Public sector workers obviously have more information about the activities they perform than anyone else does. Such information is gained by actually providing the activities and services for some time. Further, the same assistance generally offered to public employees in the preparation of bids is not typically available to private providers. This creates asymmetric information, which is beneficial to the public workers. As such, public workers enjoy less uncertainty about costs and tasks than private providers who are their competitors do. Thus, private providers generally must increase their bidding price to compensate for the greater uncertainty. This advantage, also called "learning by doing," could be substantial.

Public employees can also bid lower since they need not allow for profits, as private companies must. Usually, public workers’ costs are actually lower than private providers for several additional reasons are. These include an over-capacity of public capital, the fact that public providers are not subject to property and sales taxes, and they generally need not cover the costs of rental space. All these imputed costs and eliminated foregone revenues should be made explicit when private and public offers are evaluated.

In sum, managed competition can be unfair towards private firms that respond to some procurement documents. In the short run, it may be positive since it introduces competition to monopolistic government services, raises efficiency in service provision, and often defuses union and worker objections towards privatization. In the long run, however, considerations adverse to efficiency considerations may occur, mainly because government can only properly fill a void when markets do not operate efficiently. Thus, allowing government to operate where it is not necessary leads adversely to inefficiencies in service delivery. As the suggested criteria for government intervention clearly and correctly concluded, government should transfer its operations to the private sector unless there are strong mitigating reasons to deliver the services outside the private sector.

Obstacles Preventing Privatization

The Illinois survey showed that privatization generally occurs when there is a financial crisis or new restrictive environmental mandates. Seventy-eight percent of local governments reported that a broad review of services prompted privatization. Other less frequently mentioned reasons for privatization included internal pressures to reduce costs, external (mainly political) restrictions on raising taxes, and success stories of other similar jurisdictions in their privatization efforts.

The obstacles which often prevent privatization, in declining order of importance, included:

(1) Lack of hard and convincing evidence on the success of such efforts.

(2) General opposition or “resistance to change” on the part of elected officials.

(3) Greater concern among constituents over timely service delivery than reduced costs.

(4) An unwelcome loss of control by public officials.

(5) An insufficient number of private companies to bid on the service.

(6) Opposition from unions, line workers, and directors.

The absence of hard and convincing evidence on the success of privatization efforts appears to prevent many governmental agencies, especially in small communities, from considering the options. There is definitely a lack of information about how to evaluate appropriately whether to privatize or not, and if so, how to conduct the evaluation effort. The greater the flow of reliable information, the more likely privatization efforts will occur.

Conclusions and Outline of the Volume

Margaret Thatcher, the conservative Prime Minister of Great Britain in the late 1970s and early 1980s, signaled the world about the end of the “Big Government” era and the need to switch responsibility for the delivery of many public services to private markets. President Clinton in his 1997 State of the Union Address similarly stated that the “era of big government is over”. Former New York Governor Mario Cuomo, a liberal Democrat, stated that “Government’s role is not necessarily to provide services but to see they are provided”. Cuomo alluded, however, to services that government needs to provide because of imperfections of the marketplace.

In the U.S., the major type of privatization involves contracting out, a phenomenon that is also typical in corporate America and also referred to as “outsourcing.” The idea is that an organization should concentrate in its main mission, or core competencies,” and outsource its supporting and marginal activities to other firms that specialize in their provision. By so doing the contracting company is relieved of problems associated with managing a sizable labor force. Recent trends show expansion of state and local governments into other forms of privatization such as asset sales and deregulation.

A main obstacle to privatization is the lack of information. Many jurisdictions are unfamiliar with efforts that have been made the evaluation of these efforts, how to prepare the contract and bidding documentation, and how to monitor and follow up on the performance. As we approach the new Millennium, it is time to develop a comprehensive database of privatization efforts that will help jurisdictions learn more about available alternatives for service delivery and how they fared. This volume will hopefully advance this effort by providing insights into the thinking of some of America’s foremost “thought leaders” on the subject of innovating government.


1. Chicago Institute on Urban Poverty Policy. 1997. Does privatization Pay?” A Case Study on Privatization in Chicago, Chicago, Illinois (January).

2. Colorado Commission on Privatization, 1998. Promoting a More Competitive Government: A Report to the General Assembly.

3. Fryklund, Inge, Vivian Weil, and Harriet McCullough. 1997. Local Officials Guide, Municipal Service Delivery: Thinking Through the Privatization Option, A Guide for Local Elected Officials. National League of Cities, Washington, D.C.

4. Johnson, Robin and Norman Walzer. 1996. Competition for City Services: Has the Time Arrived? Illinois Office of the Comptroller, Springfield, Illinois, (December).

5. Keon S. Chi and Cindy Jasper, Private Practices: A Review of Privatization in State Government. 1998. The Council of State Governments, Lexington, KY.

6. Kodrzycki, Yolanda. 1998. “Fiscal Pressures and the privatization of Local Services”, New England Economic Review, January/February 1998: 39-50.

7. Mehay, Stephen, and Rodolfo Gonzalez. 1992. “Direct and Indirect Benefits of Intergovernmental Contracting for Police Services”, in Gary Bowman, Simon Hakim, and Paul Seidenstat, Privatizing the United States Justice System, McFarland Publishers, Jefferson, North Carolina: 67-81.

8. Meyer, Harvey. 1998. “Indianapolis Speeds Away”, The J. of Business Strategy, May/June: 41-46.

9. Mintzberg, Henry, 1996. “Managing Government, Governing Management”, Harvard Business Review, May-June: 75-83.

10. Payson, William and Steven Steckler. 1996. “Developing Public-Private Partnership in Infrastructure”, in Hakim, Simon et al., Privatizing Transportation Systems, Praeger, Connecticut: 33-51.

11. Pouder, Richard W. 1996. “Privatization Services in Local Government: An Empirical Assessment of Efficiency and Institutional Explanations”, Public Administration Quarterly, Vol. 20 (1), Spring: 103-119.

12. Reason Foundation, Privatization 98, Reason Public Policy Institute, Los Angeles, California.

13. Savas, E.S. “Privatization”, 1992, in Encyclopedia of Government and Politics, Vol. 2, (Mary Hawesworth and Maurice Kogan, editors), Routledge, London, and New York: 821-836.

14. United States General Accounting Office. (1997). Privatization: Lessons Learned by State and Local Governments. (March).GAO/GGD-97-48, Washington, D.C.

15. Wessel, David and John Harwood, “Capitalism Is Giddy With Triumph; Is It Possible to Overdo It? The Wall Street Journal, Thursday, May 14, 1998: 1.

16. Wilson, Pete, 1996. Competitive Government: A Plan for Less Bureaucracy, More Results. The Governor’s Office, Sacramento, California (A).

17. Wilson, Pete, 1996. California Competes: A Manager’s Workbook for a Competitive Government. The Governor’s Office, Sacramento, California (B).

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