Public Policy: Using Market-Based Approaches - Department for ...

Public Policy: Using Market-Based Approaches
market mechanism ensures that output is produced up to the point where price
equals marginal cost. If price equals the marginal cost of the expensive producer,
the other supplier will be able to expand its output which will lead to a fall in the
market price. This means that price is below cost for the more expensive producer
who will therefore cut back output, and perhaps exit the market altogether. In this
way firms with lower costs win business from those with higher costs.
The market will also provide consumers with an opportunity to chose between
firms producing higher or lower quality output. In general, unless there is a big
enough difference in price, consumers will choose producers of high quality
output over producers of low quality output. The market mechanism thus directs
business towards producers with lower costs and/or higher quality output.
Direct provision by the government removes this process and can lead to
inefficient or poor quality services being provided.
PRINCIPAL-AGENT PROBLEMS
The government’s policy goals may not be perfectly aligned with the interests of
the managers that are implementing its policies. 18 Individual departments may
expand their size, activities and budgets beyond that which is efficient in order
to increase their own importance. 19 The interests of principal and agent can also
diverge when an individual official has the scope to pursue his own political
agenda. Principal agent problems are found in both the public and the private
sector, but designing an appropriate incentive contract to re-align interests can
be more difficult in the public sector. 20 The public sector is limited in how it
compensates employees and cannot fire workers or award bonuses to the same
extent as the private sector. Furthermore, the pursuit of social welfare rather
than profit maximisation gives rise to a complex set of objectives, some of which
may be difficult to measure. An incentive contract in this case could lead to the
agent focussing his efforts on the measurable output to the detriment of the
other non-measurable objectives. 21
CAPTURE
Government officials may be ‘captured’ by special interest groups and act in
ways that are in the interests of these groups, rather than society as a whole. 22
For example, an official could be persuaded by domestic producers to impose an
18 Although this problem may arise equally for principals and agents in the private sector, designing an appropriate
incentive contract to re-align the interests of principal and agent may be more difficult in the public sector. This
issue is addressed in Tirole, J. (1994) ‘The Internal Organisation of Government’, Oxford Economic Papers 46.
19 The classic literature relating to bureaucratic behaviour and agency size is contained in:
Niskanen, W.A. (1977), Bureaucracy and Representative Government, Aldine-Atherton: Chicago and Tullock, G.
(1965), The Politics of Bureaucracy, Public Affairs Press: Washington DC.
20 This issue is addressed in Tirole, J. (1994) ‘The Internal Organisation of Government’, Oxford Economic Papers
46.
21 See Holmstrom, B. and Milgrom, P. (1991) ‘Multi-Task Principal-Agent Analyses: Incentive Contracts, Asset
Ownership and Job Design’, Journal of Law, Economics and Organisation 7.
22 See Stigler, G. (1971) ‘The Theory of Economic Regulation’, The Bell Journal of Economics and Management
Science 2(1).
40