GOVERNMENT/PUBLIC SECTOR EFFICIENCY
Abdul Rahman Turay
Commission for Privatisation of Sierra Leone
us consider a two-sector model of the economy, government and private. In
this scenario; economic theory stipulates that output in both sectors should
be optimal in equilibrium. Economists
such as Wilfred Pareto, Cournot and Nash established tests for meeting this
condition. In real life economies are never in equilibrium but the aim of
economic management is to adopt measures, which will make them approach this
position as best as possible. The disequilibria observed in most economies
have been attributed largely to inefficiencies in the public sector. It is
for this reason most governments as well as the Breton Woods institutions
have tended to search for economic management tools that could assist in
reducing the inefficiencies in the public sector in order to achieve an
overall improvement in the performance of economies.
in the public sector can be classified into two groups namely: industrial
and non-industrial. The chief distinction being that industrial activities
produce goods and services, which are traditionally, sold in markets as
distinct from the output of the non-industrial category for which there is
usually no tradable market. Public
sector industrial activities
are carried out by publicly owned enterprises, which before the
privatisation policies adopted by many industrial countries in 1980s
onwards, accounted for significant proportions of gross domestic product,
employment and gross capital formation. The different efficiencies of the
public and private sectors seems generally to be attributed solely to the
category of ownership
shall now explore the analytical and empirical foundations for the doctrine
of superior private sector efficiency relative to that of the public sector
and attempt to establish whether this distinction is determined solely
because of type of ownership.
a regime of atomistic competition economic theory stipulates that owner
managers of firms tend to seek to maximise profits (present and future
financial flows) and would use factor combinations at least cost so that the
returns to each of the factors of production would correspondingly equal to
their marginal productivity. Additionally the
optimal level of production for each firmís output is reached when the
marginal cost is equal to marginal revenue and equal to the price of the
product. When these conditions
are met then the firmsí operations are said to be internally efficient.
But some of the assumptions in this model are not usually observed in
the real world. When we relax the assumption of owner manager and take into
account the fact there are many shareholders of a firmís stock and a
distinct group of executives exists who manage the firmsí operations, we
immediately run into the problem of the relationship between principal and
agent which arises from the asymmetric distribution of information about
market conditions in which firms operate. The principals who are the
shareholders tend to have less information about the operations of their
firms than the management who operate the companies. Therefore it is
necessary for owners to design incentive schemes that can induce
managers to internalise the objective functions of the owners, namely
to seek to maximise profits of the firm as would be the case if the owners
were operating the firms. However the objective functions of management do
not contain profit as the sole independent variable.
Managerial utility functions have been postulated in the literature
that include such variables as sales revenue growth and the level of
discretionary managerial expenditure (Robin Marris Managerial Capitalism
1964 and F M Scherer 1980 Industrial Market Structure and Economic
Performance). These are powerful objectives that tend to influence the
degree of power and prestige, which can accrue to management.
It follows from this that the divergence of the objectives of the
owners of the firm and those of management will inevitably lead to
operational inefficiencies because of the possible violation of the
conditions of optimal output and internal efficiency.
the behaviour of management can be influenced in a variety of other ways.
Shareholders may set a range of dividend payments to be expected each year
from their investments and can then enter into contractual agreements with
management requiring them to make specified minimum annual dividend
payments. When shareholders dividend payment expectations are not fulfilled
significantly they may, in the case of large institutional shareholders
effect changes to management through changes in supervisory boards or as in
the case of other share holdings that are diffused, they may just sell their
shares. The mass sale of shares leads to a fall in share price and a
reduction in the market valuation of the enterprise. This then makes the
firm an attractive target for a takeover.
The impact of the threat of a take over on management behaviour
however depends, inter alia, on the precise characteristics of the relevant
capital market, including factors such as the extent of shareholder
protection afforded by the regulatory and legal environment, the constraints
imposed by international law and the effects of the extant fiscal regime.
It is noteworthy that the effectiveness of a takeover threat is to a
large extent determined by the strength of the link between managerial
effort and the probability of a takeover. Raiders often have better
information relating to the performance of incumbent management than some
shareholders, especially in the case where share ownership is diffused. The
threat of possible loss of management control of the firm through a takeover
is very often an incentive for the promotion of internal efficiency in a
firm. The conclusion to be derived from this analytical approach is that
takeovers generate an incentive for management.
But theoretical analysis and empirical evidence have yet to yield
unambiguous conclusions about the strength and effectiveness of this
managerial incentive. Some
studies have indicated the existence of market imperfections that may mar
the effectiveness of capital market disciplines on internal efficiency. Ajit
Singh (1971 and 1975) study of takeovers in the United Kingdom found only
small differences in profitability and other measures of financial
performance between companies that became take over victims and those that
did not. This result did not support the thesis that poor performance tends
to lead to an increase in take over threat. Singh also found that above a
certain size the likelihood of a take over threat diminished sharply. The
implication is that the most effective defence against a take over threat is
to increase growth by acquisitions, a strategy that satisfies managementís
factor that may influence private enterprise management behaviour is the
threat of bankruptcy by the firmís creditors if they believe that the
market value of a firmís assets is less than its liabilities. There are
two observations to be made about this hypothesis.
Firstly, if managers believe the probability of a firmís survival
is small regardless of any remedial actions they may take, they are likely
to decide to enjoy more managerial discretion in the short run than take
action to promote internal efficiency. Secondly, because managers determine the level of debt firms
carry, they would choose debt equity ratios that are sub-optimal in terms of
shareholdersí interest. This
low-level debt strategy eases the bankruptcy constraint thus weakening the
incentive for promoting internal efficiency and thereby increasing
managementís own utility function. But
when there is intense product market competition and a depressed demand for
the firmís products the threat of bankruptcy can influence managerial
of public sector enterprises are agents, initially for the supervisory
minister responsible for them, the associated civil servants and ultimately
the general public who elected the government.
As in the private sector the relationship between agent and principal
is dependent on the institutions and structures of the relevant economy.
However there are three noteworthy institutional arrangements as outlined
below, which distinguish public from private enterprises.
These distinct features are also the reason for the observed
relational difference between the management of public enterprises and their
agent, the government compared to that of shareholders and management in the
Government, the agent do not seek to maximise profits
are usually no marketable ordinary shares of public enterprises as there is
only one owner, and therefore there is no market for corporate control
is no direct equivalence to the bankruptcy effect on financial performance.
Very often lame ducks are allowed to continue with heavy subsidies that are
a drain on public sector finances.
the above discussions we can safely conclude that, in general, public sector
incentive structures are flawed and tend to have imperfections at each level
of the supervisory hierarchy. They are therefore ineffective in terms of
influencing the behaviour of public sector management.
Public interest theories of political decisions cannot provide an
adequate analytical framework for the behaviour of the principals and agents
in the public sector.
analysis suggests that the relative performance of publicly and
privately owned firms in respective of allocative and internal efficiency
depends on a range of factors that includes the effectiveness of the
monitoring systems, the degree of competition in the market, the extant
regulatory policy and the technological progression of the industry.
Evaluation of the welfare implications of privatisation will necessarily
therefore depend on an empirical assessment of each of these various
and Public sector enterprises comparative efficiency
inadequacies make direct comparisons of the relative efficiencies of
enterprises in the public and private sector domains difficult. It would be
useful and didactic therefore to extend our investigation of these
comparisons by including other explanatory variables besides type of
ownership. We shall do so by examining
empirical studies that have used financial analytical tools to make
direct comparisons of the relative efficiencies of both types of firms.
Even when data specification has not been a problem, statistical
tests have not been sophisticated enough to account of the interacting
non-separable effects of ownership, competition, and regulation on incentive
structures and consequently on the performance of firms.
empirical examination of the relative performances of public and private
firms has been extensively carried out in the US where the two types of
ownership frequently co-exist in similar market conditions and cover firms
in the generation and distribution of electricity, water and refuse
collection. In the case of electricity, studies by Meyer 1975; Pescatrice
and Trapani 1980; Fare et al 1985 concluded that after adjustments for
differences in output mixes and input prices public sector utilities
typically have lower unit costs than those privately owned.
However a study by the Edison Electric Institute 1985, stated that in
Europe electric utilities have easy access to capital and if this is
adjusted for, ownership seemed to have little effect on internal efficiency.
Studies by Peltzman1971 and De Alessi 1977 on the US pricing behaviour of
public and private electric utilities found that time of day pricing
(multi-part pricing) which was more common in private utilities can be
expected to lead to higher allocative efficiency
It was established that the jurisdictions in which the quality of
regulation is deemed high tend to have multi-part tariffs.
Public utilities in France and Britain were early pioneers of peak
load pricing systems. Studies
on US water utilities tend to suggest similar results. Crain and Zardhoohi
1978, found that regulated private water utilities were over-capitalised and
had higher labour productivity and that on balance, had lower unit costs
compared to those of public utilities.
A later paper by Bruggink 1982, found in favour of public enterprise
on unit cost criteria. The
general conclusion to be reached from these results is that where firms face
extensive regulation and little product market competition it is difficult
to support one type of ownership over another.
studies by Kitchen 1997, Savas1977 and Steven 1978 found that privately
owned firms tendering for refuse collection contracts in the US tended to
have greater internal efficiency but that this was significantly attributed
to competition. Savas found
that the gap between the unit costs levels of private and public firms was
closed by competition induced by the process involved in tendering for
contracts. A study by
Caves and Christensen 1980, on the relative performance of the two Canadian
railway companies, one private and the other publicly owned, concluded that
public ownership is not inherently less efficient than private ownership but
that the inefficiency associated with the public sector results from
isolation from effective competition. A
study by Boardman and Vining concludes that privately owned firms out-
performed publicly owned firms when both operate in an effective competitive
environment. Observations of the relative high frequency with which
privately owned firms win competitive tenders is consistent with the general
presumption, which favours privately owned firms largely because of the
efficiency derived from operating in markets which are relatively
empirical work in the UK has concentrated on competitive market structures
where the two types of firm ownership co-exist. Pryke 1982 looked at firms
operating airlines, ferries, hovercraft and the sale of gas and electrical
appliances. Using profitability and output data as proxies for internal
efficiency he concluded that in each case private firms tended to be
superior to those in the public sector. Similar results were reached in studies by Forsyth et al 1986
on airlines, Bruce 1986 on ferries. Yarrow and Rowley 1981 found a slight
deterioration in the productivity of the British Steel industry following
nationalisation coupled with significant declines in market shares and in
the rate of diffusion of new steel making processes. A UK Audit Commission
study in 1984 on refuse collection costs reported wide variations in public
sector performance costs with the better public enterprises showing lower
costs than those of private firms .The UK reports seem to support the view
that when competition is effective, the available evidence indicates that
private enterprise is generally preferred on both grounds of internal
efficiency and, subject to the absence of other substantial market failures,
on the social welfare criterion. In
competitive markets it is possible to find public sector enterprises that
are efficient but those that survive tend to be fewer.
let us now examine the results of two surveys of empirical work on the
relevant performance of firms in the public and private sectors.
Borcherding et al examined over fifty studies from five countries and
came to the conclusion that most of the studies agreed with the notion that
public firms have higher unit cost structures.
But Millwardís 1982, survey of North American literature find no
evidence for private enterprise superiority.
Borcherding et al report that out of more than fifty studies surveyed
in only nine did private enterprise fail to out perform public enterprise. Millward studied a further four studies which supported this
result. The studies agree that
the presence or absence of competition may be an important determinant of a
firmís performance. This strongly suggests that opening up a market to
competition is crucial in promoting improved economic performance. This is in line with what Kay and Thompson 1986 asserted that
in at least some cases liberalisation without ownership change will generate
substantial improvements in productive efficiency. Borcherding et al seem to concur with this view when they
conclude that it is not so much the transferability of ownership but the
lack of competition that leads to the less efficient production in public
balance one can sum up the findings of the empirical studies by stating that
ownership is a necessary but not sufficient criterion for the determination
of the relative efficiency of firms. Changes in the
structure of property rights are likely to have significant repercussions on
the behaviour of firms. Managerial
incentive structures result from a complex interaction of factors such as
ownwership, the degree of product competition and the effectiveness of the
prevailing regulatory regime in each economy.
Serious flaws in the public sector incentive systems lead to weak,
conflicting and ineffective control of public enterprises.
This makes for relatively incompetent and inefficient management and
poor performance of the institutions public sector enterprise management
operate compared to those in the private sector.
product markets are competitive it is more likely that the benefits of
private sector monitoring
reflected in improved internal efficiency will exceed any accompanying
deterioration in allocative efficiency. This view has been generally borne
out by empirical studies of the comparative performance of public and
private firms. In the absence
of rigorous product market competition the balance of advantage is less
clear-cut and much will then depend on the effectiveness of the regulatory
framework. It can therefore be
postulated that joint private-public sector partnerships may enhance the
efficiency of the public sector enterprises if the product markets are
competitive and there is a relevant regulatory framework that is designed to
promote effective competition. Therefore in addition to encouraging joint
public-private enterprise partnerships governments should liberalise their
economies and maintain regulatory institutions that would ensure barriers to
competition are removed. Performance contracts should be adopted as
benchmarks for judging the efficiency of the management of the public
sector. Where public sector goods and services can be better produced by the
private sector, their production should be hived off and offered for tender
to both the private and public sector enterprises. This policy should also
apply to the output of the non-industrial sector such as medical, education
and of other departments of the civil service if some activities can be
hived off and put out to tender by the private sector without risk.
Franchising can also be adopted as another useful tool for promoting