Sunday, January 04, 2015

Incentives: government vs. market actors

In his book Boom Towns: Restoring the Urban American Dream, author Stephen J.K. Walters uses the decision of Indianapolis to place its water treatment facilities under private management to illustrate the relative inefficiency of government in comparison to the private sector:
The political obstacles were formidable. Regulators feared that a private firm would sacrifice environmental quality in pursuit of profits. Public employees' unions were certain that talk of "cost reductions" and "efficiency gains" were code for wage cuts and job losses. In addition, there seemed little reason to hope that privatization would do much good. Two consultants' reports on the treatment plants concluded that they seemed reasonably well run; one estimated that private management could, at most, trim about 5 percent from operating costs. 
Nevertheless, [Mayor] Goldsmith and the City-County Council plowed ahead. They opted not to sell the treatment plants outright, but put a five-year concession contract up for bids. The winner was the White River Environmental Partnership (WREP), a consortium that included one of the big French water companies, a Denver-based environment management company, and the city's own (private) water supplier. WREP's winning bid was not 5 but 40 percent below the city's prior costs. Actual savings exceeded initial projections, with utility, maintenance, and capital costs all coming in well under budget.  
And environmental quality improved: the number of effluent violations decreased from about seven per year under city management to one. Though some of these efficiency gains did, indeed, come from a one-third reduction in operational staff (which led the union to fight the privatization tooth and nail in both the courts and media), the city provided a safety net for displaced workers by offering them a severance package or transferring them to other positions as they became available; within a year all had been placed. Those that remained actually banked higher wages, experienced fewer workplace accidents and injuries (which, in turn, cut workers' comp insurance costs), and reduced the frequency with which they lodged grievances with their union.  
But Indianapolis did not realize such dramatic gains in the performance of its wastewater treatment system by merely eliminating some redundant staffers. WREP had access to the technical expertise of the best engineers in the world; more important, it had a strong incentive to heed their advice. Under city management, innovative ideas--simply figure out better ways to operate or adopting new technologies--usually went nowhere because they brought nothing back to the innovator. Any realized costs savings would revert to the city's general fund to be spent on other constituencies.  
With shareholders and managers operation under a long-term concession contract, however, such savings would go do the bottom line and fuel dividends, bonuses--and even the aforementioned higher wages. Indeed, once workers are freed of unions' work rules and across-the-board compensation formulae, they frequently offer up the most useful suggestions about how to get their work done better for less--and find private managers far more willing to listen than their public-sector counterparts. 
It's not a matter of smarter people, but rather the differing incentives which face actors in market-based and public sector settings. Given this reality, shouldn't we desire as much of our world as feasible to be subject to market incentives rather than those faced by government? It's also notable that this kind of innovative thinking occurred at the local government level, which--unlike Washington--often can't simply borrow its way out of trouble.

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