Economics & Management of Privatization

1. Economics & Management of Privatization Professor Simon Hakim hakim@temple.edu hakim@technion.ac.il

2. Lecture 1 • Definition: Political Science, Economics • The Concept of Public Goods: Adam Smith • Characteristics of Goods that Require Intervention • Techniques of Public Sector

3. Definitions—Public Administration • Relying more on private institutions of society and less on government to satisfy people’s needs. Private institutions include businesses operating in marketplace, voluntary organizations– religious, neighborhoods, civic, co-operatives and charities. Individuals, family, clan or tribe. • Act of diminished role of government or increased role of private sector in an activity or in the ownership of assets. • Act of transferring government enterprise or assets to the private sector • Webster’s: Making private, especially changing from public to private control or ownership.

4. Definition: Economics A move of an asset or activity from bureaucratic government monopoly towards competitive markets.

5. Public Goods: Adam Smith • The need for National defense • The duty of protecting every member of society from injustice or oppression of every other member of society • Establish and Maintaining highly beneficial public institutions and public works which are of negative profit nature if supplied in small quantities • The duty of meeting expenses of ruling powers.

6. Public Intervention in Marketplace • Pure Public Good: Collective consumption (non-divisible) with non-exclusion, and non-rivalry in consumption. MC=0. Motivation for free ridership. • Externalities: Positive and negative; Production and Consumption. • Monopolistic Power. • Asymmetric information between the consumers and producers in the market • Equity.

7. Pure Public The case of MC=0 and constant is typical for pure public good. A non-competitive provider will produce at MR=MC and eliminate a significant part of Consumers’ surplus. Example, a road without congestion. Degree of collective consumption VS. Size of relevant interacting group.

8. Mapping of Public And Private Goods

9. Dichotomy of Goods & Services

10. Exclusion & Consumption Properties of Goods & Services

11. Externalities Definition: By-product of activities that escape the price mechanism, and may be of positive or negative nature. Government role is to internalize externalities such that the price includes it. In case of negative externalities the product is over produced and at a lower price than it should (social). Positive externalities cause under production of the good at a higher price than socially desired.

12. Natural Monopoly A single provider in the market. Absence of competition may result of significant economies of scale, technological superiorities, and/or asymmetric information that over time eliminated all competitors. Entry of new competitors to increase supply and thereby lower prices is usually infeasible. Gov’t intervention is

13. Natural Monopoly (cont.) Is aimed to control prices through regulation. Examples include local utilities. Improved technology increase availability of close substitutes and leads to elimination of the need to regulate. Natural monopoly results of economies of scale, technological superiority, asymmetric information. Overtime, one provider prevails. Consumers’ surplus in the case of a monopoly is smaller than that results in perfect competition. Government regulation sets the price to be lower and as close as possible to that of perfect competition. Action could be on the quantity.

14. Asymmetric Information Food contents, medicine, Enron, corporate corruption Here the consumers have no knowledge on the contents of their products while learning about it requires very high cost. Government needs to protect the consumers.

15. Equity Requires government intervention. Efficiency VS. Equity. Shortcomings of perfect competition. Voluntary activities to reduce inequity. Progressive taxation.

16. History of Privatization Peter Drucker suggested contracting out. Milton Friedman. Thatcher elected 1979. BP (79), British Aerospace (81), National Freight Corp (82), Cable and Wireless (83), Jaguar (84), British Telecom (84), British Aerospace-final portion of holdings (85), British Gas (86), British Airways (87), Rolls Royce (87), British Airport Authority (87), water utilities (89), electric utilities (90), mandatory compulsory tendering (compet bidding) of local gov’t services (89).

17. History of Privatization US: little privatization by sale by Fed. Few state owned enterprise. Contracting out: data processing, food services, building maintenance, guard services. Local: waste collection, street cleaning, ambulance service, park maintenance.

18. History of Privatization World: Late 1980’s: Mexico, Brazil, Chile, Argentina elected presidents who adopted strong privat. Policies. China: Agriculture (78), eliminating state owned and collective farms and allowing private farming. In the 80’s: private sector industrial and retail operations, multi ownership, joint ventures. 89: Collapse of socialist block.

19. Political historical Discussion • Rise of Communism and greater state involvement in marketplace: Eastern block • Rise of Socialism in Western Europe • Rise of Fascist regimes in South and Central America • Change of trend: Thatcher and Reagan • Collapse of Eastern European block • Liberalism in Western Europe and Americas • The role of privatization

20. Forms of Privatization

21. Forms of Privatization

22. Forms of Privatization • Divestment: Shedding an enterprise or an asset. One time affair. Sold or given away. • Free transfer: Given away to employees, users, customers, previous owners, or the public at large • Sale: to joint venture, private buyer, the public, employees, users or customers.

23. Forms of Privatization • Delegation: Requires a continuing active role for gov’t. Remains responsible for overseeing the results. • Contract: for part of service, for total management. Solid waste collection, street repair, street cleaning, snow removal, tree maintenance, loan processing, data processing, audio visual services, food, mail and filing services. • Franchise (concession): exclusive right to sell a service or product to the public. 1. Use of the public domain in the course of carrying out their commercial activities– airwaves, air space, underground space. Examples, broadcasting, airlines, bus and taxi co’s, electric, gas, water, telephone.

24. Forms of Privatization (Delegation forms cont.) 2. A lease. Government owned tangible property is used by a private lessee to engage in a commercial enterprise • Grant: private entity does the work-subsidy, grants for public transit, low income housing, maritime shipping. To run a bus service, to do research, to promote the arts. Contracts are more specific. • Mandate: Gov’t requires private companies to provide services at their expense. Ex. Unemployment Compensation. Replacing Gov’t by mandatory indiv retirement accts.

25. Forms of Privatization • Displacement: Passive process as markets develop to satisfy needs. • By default: Gradually the public looks for the private sector. Ex. Municipal tennis courts and other rec. facilities. Commercial ventures, voluntary groups like charitable, social, philanthropic and community org. Ex. Police is replaced by private guards. IN trans. gypsy cabs, commuter vans, minibus systems and other unofficial or technically illegal trans. Providers emerge as public means are inadequate. Private co’s finance, build, operating, owning roads, bridges, prisons. Ex. tunnel connecting England and France.

26. Forms of Privatization • By Withdrawal: Gov’t shuts down failing public enterprise or accommodates private sector private sector expansion. • By deregulation: State monopoly vs. competition. Privatization if the private sector challenges a gov’t monopoly and even displaces it. Packages and express mail.

27. Delegation: Contracting Out Most common in the US (28% of all services). Mandatory for municipal services in the UK. Managed competition: bidding for contracting out that includes the gov’t agency. Goldsmith: “A city could run with its mayor, a police chief, a planning director, a purchasing agent, and a handful of contract monitors”. Steps in contracting for service: • Consider the idea of contracting out. • Select the service • Conduct a feasibility study • Foster competition • Request expression of interest or qualifications • Plan the employee transition • Prepare bid specifications • Initiate a public relations campaign • Engage in “managed competition” • Conduct a fair bidding process • Evaluate the bids and award a contract • Monitor, evaluate, and enforce contract performance

28. Contracting Out Success in waste management: collection, disposal, extracting energy and recyclables from the waste stream, and to treat hazardous wastes. Principal-agent problem: The principal bears 1. the cost of providing incentives to encourage the agent to pursue the goals of the principal. 2. the cost of obtaining information and monitoring the agent to reduce opportunistic behavior. 3. the cost of any residual opportunistic behavior by the agent. A gov’t with budget problems is a good candidate for contracting out. Loss of hospital accreditation by the State, court’s order the closure of a municipal landfill, sudden need for a large public facility-- all necessitate contracting out.

29. Contracting Out: Actual Process Wastewater treatment plants in Indianapolis, 1993. • Mayor creates Review Committee (6 mayoral appointees, and 2 from City Council) • Review Committee issues RFQ to 28 Cos. • 7 Responses are received including one from the current managers of plant • Committee reviews and cuts down to 5 • City provides $15K for consultants to help existing managers: Cost estimate and preparation of RFP • RFP are issued to 5 qualified teams • Teams of all 5 qualifiers visit separately the plant • 5 qualifiers submit proposals and prices • A technical and financial consultants are hired to help the Committee • 3 of 5 including existing management are rejected • Each finalist briefs the Review Committee • Review Committee visits plants operated under contract by 2 finalists • Review Committee picks the winner • Winner starts contract operation

30. Contracting Out: 2. Select the Service Criteria • Service with no legal or contractual impediments to contracting • Easy to carry out competitive contracting • Hard services for which easy to write enforceable specifications • Stand-alone service • Can be segmented by location into 2+ contracts • Services that have been successfully contracted out elsewhere • “Yellow pages test”. Enough, responsible and experienced bidders • Services for which part timers can be used. Significant savings since gov’t cannot readily employ part timers • Services where gov’t operation is overstaffed, poorly managed or could be re-engineered. • Services that are subject to public complains • Services where employees and union resistance can be overcome • Services where overpowering political opposition will not result • Services where in-house monitoring expertise is available.

31. Contracting Out: 3. Feasibility Study • Establish current cost to establish a baseline against which to compare prices • Assess quality of current operation—complaints, measuring performance, conducting surveys • Public cost relies on published budget. Need for ABC accounting which includes: • Capital expenditures which often are not included in operating budgets • Interest costs on capital expenditures • Costs of supplies- fuel for vehicles that appear in a different category of budget • Fringe benefits • Budgetary pensions • Cost of labor borrowed from other agencies or hired seasonally and are not included in the analyzed budget. E.g. hierarchical and hidden costs. Or, many attorneys budgeted by the DOJ work full time defending the Bureau of Prisons against suits brought by litigating prisoners. • Foregone property tax and OC of building and land used by the activity • Cost of premiums paid for liability and fire insurance

32. Contracting Out: 4. Foster Competition It is best to have multiple competitors. However, when there are marginal competitors it is best to negotiate bids with handful of clearly eligible contractors after the qualifying round. Best for contractors of hospitals, prisons, social and professional services. Often due to bureaucratic behavior of gov’t there are only few bidders and/or high bids to compensate for it. To foster competition– • divide the geographical area to smaller units as long as econ of scale are not adversely affected. • give a long lead time to bidders • publicize and use the web for the bidding • provide sufficient information • award enough contracts and permit a large number of bidders to get contracts. • Minimize “incumbent advantage” to encourage new contractors to bid. Philadelphia did just that by including in the bid for the maintenance of street lighting detailed information on equipment and practices used by the incumbent contractor • Avoid request for sensitive non-essential business information to the procurement like profits, wages of managers/employees • Avoid restricted contracts for nonprofit organizations but keep it open for all. Such restrictions are often used for local political patronage (e.g. social foster care agencies) • When service is site based like center for homeless, the owner of the facility has an advantage in such a bidding. It is suggested to separate the rent from the operation to encourage companies that could provide the service however do not own the (a) facility.

33. Contracting Out: 5. Express Interest or Qualifications (RFEI) When initially considering privatization, gov’t may be unsure about the exact nature of the proposed contract. So, it announces RFEI to prospective bidders, pre-bid conference to discuss the issues, checking the submission of the firms, prepare a list of firms to which RFP or an invitation to bid is issues.

34. Contracting Out: 6. Plan the Employee Transition Biggest problem is how to handle with redundant workers and the prospect of labor unrest. Surveys showed that most workers are hired by the private contractor, followed by early retirement, severance pay, attrition, redeployment in other public agencies. Only few are fired.

35. Contracting Out: 7. Prepare bid specifications Contract wording should be in ordinary language, accurate and unambiguously. The contract should not specify exactly how the work should be done but merely the output quantitative specifications. Gov’t should allow freedom of contractor to employ the people at salaries and in procedures that achieve the contract specified outputs. “Hard” services that involve tangible and visible physical results are easier to write specifications in output and lend themselves to contracting out. “Soft” services that involve social workers are more amenable for contracting out.

36. Contracting Out: 8. Initiating Public Relations Campaign Strong opposition is almost certain to surface by public employee unions, private firms that want to avoid competition, or special interest groups. Aggressive campaign in support of privatization should include a coalition of civic associations for better gov’t, neighborhood groups dissatisfied with poor services, minority businesses that see opportunity in providing such services etc.

37. Contracting Out: 9. Managed Competition • Effective for short term contract or where capital expenditures are required • Allows the management to work with its labor force • Improves employees’ morale and builds community support • Reduces the possibility of collusion among private providers • Induces private firms to submit better bids Mandatory competitive bidding by gov’t agencies for routine functions was introduced in the UK. Also, requirement of gov’t agencies to maintain separate accounts of income and expenditures and to achieve a prescribed rate of return on the capital equipment they employ. (Local Gov’t Act, 1988). Included refuse collection, street cleaning, cleaning of public buildings, vehicle and ground maintenance, and food services. Result: Many services were won by in-house departments with savings of 20% and reduction in manpower of 20-30%.

38. Contracting Out: 10. Fair Bidding Process • Widely advertise the RFP • Allow enough time between announcement and due date • Hold a bidders’ conference to address questions • Use internal team and an outside consultant to evaluate proposals using clear criteria and an agreed upon score system • Avoid asking for too many bid prices. (e.g. price for year 1, year 2…) This will create favoritism.

39. Reasons for Privatization Political Science view) • Pragmatic: Greater efficiency in the production of G & S. Dissatisfaction with gov’t performance. • Ideology: Less gov’t. Gov’t plays a smaller role than the private sector. • Commercial: To do more work at profit. • Populist: Better society by giving people greater power through the marketplace while diminishing the power of large public bureaucracies.

40. Reasons for Privatization (The Economist View) 1. Improve economic efficiency 2. Strengthen the share of the private sector in the economy 3. Reducing the role of government in the marketplace 4. Improve the financial stance of the public sector 5. Develop better capital markets 6. Use the revenues generated by the privatization for other social, security or infrastructure purposes.

41. Reasons for privatization varies by economies The relative importance of the reasons depends upon the characteristics of the economy in question. In a nation where capital markets are weak– reason 5 dominates. In a nation that changes its structure (from Communism) then reasons 2, 3, and 5 are central. In a developed economy where the private sector is strong and so are capital markets then reason 1 applies.

42. Keys for Success (in Declining Importance) • Having committed political leader (s) to champion the initiative. E.g. a governor, mayor, or several legislators. Flexibility in adjusting strategies when problems arise in the implementation. Maintenance of momentum. • Establishing an organizational and analytical structure to implement the initiative. • Enacting legislative changes and/or reducing available resources to encourage greater exposure to competition. Signaling managers and employees that the restructuring efforts are real. • Developing reliable Activity Based Costing (ABC) accounting to determine performance of the gov’t agency and the feasibility of private sector provision of service. Cost data on individual activity and not the traditional agency wide accounting system.

43. Keys for Success (Conti.) • Involving employees and local unions in theprivatization process. Unions concerns and political influence led to legislation that made privatization in MA more difficult. In Indianapolis, employees are involved from early stage. Workers trained in ABC and allowed to compete. Front line workers were given decision-making power. Some supervisory jobs were eliminated, training to workers responding to RFP, safety net for displaced workers. A 1989 National Commission on Employment Policy survey showed that 24% of contracted out public services were transferred to other gov’t jobs.58% went to work for the private contractor, 7% retired, and only 3% laid off. • A monitoring body should be established by gov’t to assure compliance with the designated contractual terms.

44. Problems with traditional Contract Out Model Infrastructure controlled by gov’t: 1. Separate contracts with private agencies 2. Labor disputes 3. Disputes between the planners and the contractor 4. Lowest bidder contractor performs low-quality workmanship 5. Concealed or unforeseen conditions 6. Huge task of renewing the public infrastructures, and insufficient funds.

45. Public Private Partnerships (PPP) Definition: PPP is an arrangement of roles and relationships in which 2+ public and private entities coordinate in a complementary way to achieve their separate objectives through the pursuit of common objectives (s). Private design, finance, construction, maintenance and operation of a project for public use for a specific period of time. When time expires, title reverts to gov’t. The private sector aids gov’t in identifying new private financed profit-making facilities, and seek out new projects that otherwise have to wait until public funding becomes available. The public sector investigates feasibility of project, execute the contract, choose the private partner, regulate prices, establish and monitor performance standards. BOT is a general term for PPP. A concession is granted to a contractor to design, finance, operate and maintain for 10-30 years. Contractor charges tolls for the use of the facility.

46. Forms of PPP From mostly Public to mostly private • Fully public • DB: Design Build • DBFO: Design, Build, Finance, Operate • BOT: Build. Operate, Transfer • BTO: Build, Transfer, Operate • BOOT: Build, Own, Operate, Transfer • BOO: Build, Own, Operate • Fully Private

47. Forms of PPP • DB: A contract with a private contractor to provide architecture/engineering design and construction services • DBFO: Contractor responsible for these services and is compensated by specific service payment by gov’t during life of project. No actual tolls are collected by private contractor. Here payments by gov’t—cost to taxpayer. Still efficient since construction & operation by a private entity • BOT: A concession is granted to a contractor to design, finance, operate, and maintain for 10-30 years. Contractor charges tolls for the use of facility. • BTO: Build, Transfer, Operate. The gov’t then leases the facility back to developer under a long term lease. • BOOT: Build, Own, Operate, Transfer. Ownership with the contractor until the end of the concession period and is transferred free to the gov’t. • BOO: Outright privatization without a transfer of ownership to gov’t. At the end of the concession, the original agreement can be renegotiated. • Wraparound addition: The private developer constructs an addition to an existing public facility and then operates the entire facility for a fixed period of time or until the developer recovers costs plus a reasonable return on investment.

48. Reasons for PPP • Greater efficiency in the use of public resources. State and local gov’ts save 10-40 percent • PPP are means of increasing investment in infrastructure particularly utilities and transportation • Needs for social infrastructure– hospitals, prisons, schools, housing

49. Advantages for Gov’t of PPP • Profit oriented businesses identify new projects that otherwise wait till gov’t funds are available • Private sponsors and commercial lenders assure financial and tech feasibility of project • Private sector can access private capital markets to substitute hard to get gov’t sources • Private sector builds faster and more cost effective than gov’t. Less bureaucracy and procurement rules • Private sector operates facilities more efficiently due to profit motives • Private firms provide more tax revenues • Private sector shares or accepts risks otherwise borne by public sector • Private sector transfers technology and provides training to gov’t workers

50. BOT Model Usually a large project requiring consortium of designers, builders, financiers and more. Contractor enters into 4 agreements: • A concession agreement with host gov’t • A construction contract usually DB type. It may be a member of the bidding consortium • An operation and maintenance agreement with operator of facility. It may be a member of the bidding consortium • Loan agreements. Funds flow through concession co.