Friday, June 10, 2011

Efficiency Vs Cost trade-off in infrastructure

Conventional wisdom would have it that governments are not only very inefficient but also expensive in delivering public services. It is also widely believed that private sector is not only more efficient but can also deliver the same service more cheaply. In other words, in contrast with the private sector, government service delivery offers the worst of both worlds - inefficient and expensive. How does this conception square up with reality?

The cost-efficiency curves for a typical market for public service delivery in developing countries would look something like in the graph below.

Atleast for the short term (given the same investments), the cost of delivering a service at the same efficiency is much higher in the private sector than the public sector. See this, this and this (there are many more other reasons). This raises the issue of whether people are willing to pay the higher prices required to access these basic public services.

However, certain markets are more amenable for private contracting. The curves for such markets would look like this

In these markets, to achieve efficiency beyond certain point, Ee, the private sector is easily more cost-effective than the government. In such cases, beyond a basic minimum level of efficiency, Ee, the private sector can achieve the same efficiency as government, Eg, at far less cost than government (P1-P2).

In conclusion, public provision of services may be more cost-effective in most public infrastructure services. However, if the private sector is made to deliver the same services, at greater efficiency, that would have to come with a cost. In the absence of willingness of users to pay the higher price, governments may have to bear the higher cost of these services by subsidizing service delivery.

But in certain infrastructure services like airports, ports, power generation, and telecoms, which are single location services, involve considerable professional expertise in their management, and where cost recovery is possible (due to the economic profile of its users), it may be prudent to rely on private providers. They can deliver such services in a more cost-effective manner than government service providers.

PS: The graphs are intuitive representation and not based on any data.


KP said...

Dear Gulzar,

my thoughts,

The principle underlying the preference for private sector participation is as follows -

1. skill creation and efficiency related upgradation is of vital interest to the private sector - since the ability to extract larger share of surplus is through higher pricing and/or higher efficiency.

2. A well functioning government body should be in a better position to enforce contracts and service level agreements with the private sector, which is better the government regulating itself as a regulator and provider of the service. ( I don't see elections as an appropriate response mechanism to correct badly maintained roads / filthy streets)

3. Between the private sector extracting a larger profit and a bureaucracy extracting a larger rent (mostly through inefficiency) - we should in principle prefer the former.

In the process of opening up larger sectors of the economy to the private sector, we should hopefully create a more vigorous market that will fill the gap in capacity that you have highlighted (large project skills / resources).

Since our current level of public oversight over public funds ( and the fund managers) is so minimal - the preference is to create a competitive market.

The initial steps - that you are taking - will hopefully be the way forward and create a template. ( afer all the transfer of such services to the private sector is also an opportunity to create new vested interests and requires careful steps).

So whether single location or otherwise - delivery expertise should be from the private sector and regulatory frameworks and enforcement should belong to the government.


gulzar said...

excellent! I agree with everything you say.

it is a matter of great concern that government agencies have very limited capability to formulate and manage contracts, leave alone enforcement. i am not sure whether governments even today recognize the increasing importance of building capacity to manage contracts.

the point about choosing excessive profit seeking by the private sector over bureaucratic rent-seeking and inefficiencies is important. for one, it implicitly recognizes the inevitability of wastage and excesses in large project implementation.

more importantly, there may be some very interesting dynamics at work here. india's polity and society has an inherent tolerance for bureaucratic inefficiency and deep hostility to private profiteering. this environment sets the stage for a mutually beneficial and close nexus between private interests and the politician/bureaucrat.

the danger with this scenario is that we could end up with the worst of both worlds - inefficiency and profiteering. after all if the relationship develops in such a environment, the incentives of the private parties also get mis-aligned - poor quality works, high project costs, not so competent bidders etc. a low-efficiency equilibrium develops. and this is happening in many sectors in the country today.