Lecture 10: Public Sector Decision Making

Market Failure

Market - group of buyers and sellers linked by trade in a particular product or service

Prices in a market should reflect all the benefits and costs of production to society

When prices do not reflect this, there is market failure

Market failure occurs when a market, left on its own, fails to make decisions where resources are allocated efficiently

• Aggregate costs are higher than aggregate benefits

Market Failure Defined

Markets fail for several reasons:

• No market for those affected to communicate their costs

• Market has insufficient information about gains/losses

• A monopolist can influence price or output

• Someone decides not to do something that creates benefits to others

Remedies for Market Failure

• Society will seek a means of correcting the failure

• Social, environment, or ethical issues not captured by transactions are called externalities

• Liberal economists often advocate for internalizing externalities

• Formal methods to remedy market failure:

1. Gov’t-set policy instruments (eg standards, bans, permits, or quotas)

2. Ability to seek compensation in courts

3. Gov’t provision of goods and services, such as health care, transportation, and education

• Informal methods can also be effective:

  • Boycotts, protests, dissemination of information

Decision Making in the Public Sector

Public production in Canada is mainly in two classes:

1. Services which are not practical to require people to pay for: police/fire protection, national defence, maintenance of city streets

2. Services for which scale economies make it inefficient to have more than one provider, ie, natural gas, electricity

   • Single provider may charge excessive prices or be inefficient (monopolist)

   • Alternative is for gov’t to monitor/regulate performance

Benefit-cost analysis (BCA)

Project evaluation method often used in public sector

• general framework for assessing the gains/losses of alternative projects when a broad societal view is needed

• Also used in the private sector

Before conducting a BCA, it is important to identify:

• Who will benefit from the project?

• Who will pay for the project?

Identifying these two “points of view” clearly avoids confusion about what to include/what not to include

Generally, members of society are the users/beneficiaries of project services, and the gov’t is the sponsor

Challenge may be that there are several reasonable points of view

→ Each with a different set of users or sponsors to be included

This can lead to ambiguity/controversy over the results

Identifying and Measuring the Costs and Benefits of Public Projects

• Generally classified into the initial capital costs and ongoing operating and administration costs

• If the project generates savings, these are deducted from costs to produce a net cost to the sponsor

• Some costs may be directly attributable to a project (direct costs), while others may be stimulated indirectly by the project (indirect costs)

Identifying and Measuring the Benefits of Public Projects

• The benefits of a project to society include value of all goods/services that result from the project or program

• Some of the effects from a project may be negative

• These negative effects are referred to as social costs and are subtracted from benefits to obtain a net measure of social benefits

• Some of the social benefits and social costs may be directly attributable to a project (direct benefits), while others may be stimulated indirectly by the project (indirect benefits)

• Challenges arise because the benefits may not be reflected in the monetary flows of the project

  • ie real cash flows for road construction (costs, tax revenue)

  • vs intangible cost of traffic disruption during road construction

• Intangible goods/services can be challenging to value

  • ie improved health and safety, value of noise abatement, value of the environment

• Two methods used to value “intangible” benefits/costs:

  • Contingent valuation

  • hedonic price

Benefit-Cost Ratios

Same comparison methods that are used for private sector projects are appropriate for public sector projects

Benefit-cost ratios can be based on Pw or Aw

The conventional benefit-cost ratio (BCR) is given by:

BCR = Pw(users’ benefits)/Pw(sponsors’ costs)

A project is considered desirable if its BCR > 1

Modified benefit-cost ratio

In addition to BCR, a modified benefit-cost ratio (MBCR) is also commonly used

In MBCR, the sponsors’ operating and capital costs are separated to provide a measure of the net gain per dollar invested

The modified benefit-cost ratio (MBCR) is given by:

MBCR = [Pw(users’ benefits) - Pw(sponsors’ operating costs)] / [Pw(sponsors’ capital costs)]

Evaluating independent projects

Evaluate economic viability of projects with BCR/MBCR

• For independent projects and mutually exclusive projects

For independent projects use following decision rule:

Accept all projects with a benefit-cost ratio greater than 1

Evaluating mutually exclusive projects

To use benefit-cost ratios to choose among mutually exclusive projects, perform incremental analysis

Suppose mutually exclusive projects, X and Y, with Pw of benefits B_X and B_Y & Pw of costs C_X and C_Y

We discard projects with a BCR < 1

If both projects have BCRs > 1, we rank the projects in ascending order by the present worth of costs

If C_X >= C_Y, then form the ratio of the differences in benefits and costs:

BCR(X-Y) = (B_X - B_Y) / (C_X - C_Y)

If BCR(X-Y) > 1, X is preferred. Otherwise, Y is preferred

If C_X = C_Y (in which case the ratio is undefined), we choose the project with the greater present worth of benefits

If B_X = B_Y, we choose the project with the lower present worth of costs

Ambiguities in BCRs

• It may not be clear whether certain positive effects are benefits to the public or reductions in cost to gov’t

• Or, whether certain negative effects are dis-benefits to the public, or increases in costs to the gov’t

• Differing results means that a comparison of BCRs may not carry the meaning intended

The MARR and the Public Sector

• Private institutions concerned with generating wealth

• Typical projects include health, safety, education programs, cultural development, and infrastructure

• Hence, MARR for a public institution lower than private

• In evaluating public sector projects, the MARR is used in the same way as in evaluating private sector projects, it captures the time value of money