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Privatization and the public sector: Shifting activities to the private sector

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1985
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Samuel Paul

In most countries, public or collective goods and services, such as national defense, law and order, and street lighting, have always been made available by the state. Goods and services that cannot be denied to one individual without denying them to all must be supplied collectively, for a private entrepreneur supplying them could not force the community as a whole to pay him, nor could he prevent anyone who did not pay him from consuming his products.

In all countries, governments have gone beyond the provision of public goods and services. They have invested in and promoted the production and distribution of a variety of private goods, through the allocation of public resources and the creation of organizations under public auspices. Private goods are those such as food, clothing, or medical care whose consumption by one person precludes consumption of the same unit by another. When such goods are supplied by the state, it is because it is believed that their quality or quantity of supply would not be adequate if it were left to the private sector. Among the reasons for this belief are the rudimentary state of the private sector, where entrepreneurs are few and most businesses small and unsophisticated, the inability of the private sector to raise enough resources for investment, a wish to promote a particular distribution of consumption or income, and the urge of governments to control the “commanding heights” of the economy. Sociopolitical considerations, such as the fear that key activities will be dominated by expatriates or by a local ethnic group, are often decisive. In some cases, too, the public sector has been bloated by politicians and bureaucrats in search of power and prestige.

Large investments in infrastructure by governments, made possible in part by higher domestic savings rates and foreign aid, were a major force behind the developing countries’ marked acceleration in economic growth rates since World War II. But despite considerable support by many political leaders and development planners, experience with the public provision of goods and services over the past three decades has generally been disappointing. In country after country, unbridled state expansion has led to:

• economic inefficiency in the production activities of the public sector, with high costs of production, inability to innovate, and costly delays in delivery of the goods produced;

• ineffectiveness in the provision of goods and services, such as failure to meet intended objectives, diversion of benefits to elite groups, and political interference in the management of enterprises; and

• rapid expansion of the bureaucracy, severely straining the public budget, causing problems in labor relations within the public sector, inefficiency in government, and adverse effects on the whole economy. These problems have led many governments to undertake programs of public sector reform and, pushed by a need to curb public expenditure, to re-evaluate the possibilities for shifting publicly managed activities into the private sector.

Types of goods, production modes

Of the different types of goods and services a society requires, reference has already been made to collective goods and private goods. In between are toll goods and common pool goods. Toll goods can be produced through the private market, but with some collective action. Electric power and water are examples of toll goods that can be produced in the private sector but may need to be regulated since they are usually produced by monopolies and since governments want to ensure universal access. (This is because the size of the investments needed, especially in local distribution, makes it uneconomic to have several competitors supplying these goods in the same area.) Common pool goods and services are those whose continued supply will not be assured through the private market, as individuals will tend to squander them. Examples are underground water resources, oil or mineral deposits, wildlife, and lunch programs for school children or the underprivileged. Collective or cooperative action is needed for orderly exploitation or preservation of such goods.

Different types of goods and services can be provided under different types of institutional arrangements, listed here in descending order of government involvement:

1. Production and delivery by government.

2. Intergovernmental agreements for production and delivery (contracts to local government by central government).

3. Government contracts to private parties for the supply of goods and services.

4. Government franchise to private parties to produce and sell goods and services.

5. Government grants/vouchers to consumers to buy goods and services.

6. Joint ventures (government investing jointly with private parties).

7. Voluntary service.

8. Market (private entrepreneurs supplying goods and services).

Combining these alternative institutional arrangements with different types of goods yields a broad set of possibilities which is set out, with examples, in the accompanying box below.

Recent evidence shows that even in those types of goods whose provision requires strong collective action, private enterprise can play a role in at least some phases of production or delivery. In most developing countries, however, irrespective of the type of goods, government production and delivery play a large if not dominant role. Where such an overextension of the state exists, it is useful to consider the following two questions: What are the alternative routes to privatization available to governments? Under what conditions will privatization yield desirable outcomes?

Options for privatization

The burden on the public sector can be reduced in three different ways. First is divestiture, which entails the sale or closure of state-owned industrial enterprises. Bangladesh, Chile, Jamaica, Pakistan, the Philippines, and Sudan, among developing countries, offer examples. In the Republic of Korea the government pioneered the establishment of basic industries such as oil refining, steel, and machine tools, and then sold them to the private sector once their profitability was established, using the funds raised to pioneer other industries. However, governments rarely want to sell their profit-making industries, while private parties are reluctant to buy those that are making a loss, and the political risks of closing state enterprises are high. Hence, divestiture is likely to be the least palatable of the three methods to LDC governments. An alternative likely to be more attractive is the leasing of state-owned enterprises or the use of private management contracts to strengthen unsuccessful enterprises whose turnaround seems feasible.

Second, governments may contract out services they have planned and specified to other organizations that produce and deliver them. Franchising—authorizing the delivery of certain services in designated geographical areas—is common in utilities and urban transport. Contracting is common in public works, defense, and many specialized services. Grants and vouchers may be given to consumers to subsidize items such as food, health care, and education when these are offered by the private sector. Where suppliers compete for contracts and there is no loss of economies of scale, contracting is efficient. But there is scope for corruption in contracting, and long-term contracts tend to encourage monopolistic behavior by the private supplier. Contracts for road construction and maintenance are common in countries such as Brazil, Colombia, India, and Kenya. In agriculture and urban development in the Philippines and in water supply in the Ivory Coast, private contracts have played an important role (see box above).

Types of goods and modes of production/delivery
Type of goodFeasible modeExamples
PrivateMarket, voluntary service, grant/voucher, joint venture1) Food, clothing, housing, privately produced and sold.

2) Consumers produce own food, clothing, housing.

3) Food stamps used to subsidize the poor.

4) Food, clothing, housing produced jointly by government and private sector.
TollFranchise, contract, joint venture, market1) Electricity, water, telephone, and highway services Supplied privately or under contract to government.

2) Electricity, water, or communication services delivered jointly by government and private sector.

3) Market produces these goods subject to government regulation if natural monopolies emerge.
Common poolContract, grant/voucher, government production1) Underground water and mineral deposits exploited on a contract basis.

2) Medical care provided through a grant/voucher system. These are in the nature of transfer payments, but they avoid the need for the government to supply the services directly.

3) Government produces and sells medical services or water.
CollectiveContract, voluntary service, intergovernmental agreements, government production1) Government produces and delivers defense service, street lighting.

2) One level of government contracts another for educational, urban, or hearth services.

3) Community or voluntary group provides, e.g., street cleaning, rural water supply maintenance, or family planning services.

4) Government contracts out road maintenance, research and development, or sanitation to private sector.

Third, governments could withdraw from the provision of many goods and services, leaving them wholly or partly to the private sector. Sometimes the introduction of competition acts as a force for efficiency and innovation. Voluntary organizations significantly augment the work of the state in education and health services in many countries. Private entrepreneurs supply urban and rural road transport in many countries, whether exclusively or to supplement public services. Farmer cooperatives successfully deliver services in Argentina, Chile, India, and Zimbabwe, and private tubewell irrigation has been successful in India and Pakistan. A major problem in LDCs, however, is getting private suppliers to provide services to remote rural areas, where many of the poor live, and to take a long-term view of customer needs, rather than maximizing short-term gains.

Private provision of drinking water

• In Santo Domingo, Dominican Republic, ten private companies provide drinking water to the public, subject to checks on quality by the Ministry of Health and controls on prices set by the Ministry of Public Works. The companies obtain water from private sources, purify it, and distribute it by truck.

• A district of Santiago, Chile, has obtained all its water and sewerage services from a private company since 1943. The company currently has 43,000 connections and covers all residents. Tariffs are approved by the Government.

• Abidjan, Ivory Coast, obtains its water from a private firm originally established as a wholly owned subsidiary of a French firm, and now jointly owned by the latter, private investors, and the Government. Since 1973, this firm has been responsible for water supply throughout the country. Water supply in the Ivory Coast maintains one of the highest standards in West Africa. The institutional separation of investments from operations, tariffs that reflect costs fully, careful public scrutiny of costs, and the autonomy of the company are among the major reasons for its good performance.

Even if they do not divest, governments can reduce the burden on tax revenues by imposing user charges for services provided by the public sector. User charges are public prices for public products; they are applicable to those services with readily identifiable users who benefit substantially more from the service than nonusers, and from whose benefits nonusers can be readily excluded. For urban services such as water, power, telephone, or refuse collection, user charges are more efficient than general taxation. When services are provided out of general taxes, low-income groups may subsidize high-income groups if both groups pay general taxes and the rich have greater access to the services. When user charges are enforced, citizens can be offered different levels and qualities of service, according to what they can pay for. Moreover, overcrowding and excess demand for services occur when users do not directly pay for them; user charges encourage more cost-effective behavior. Poorer groups in the community can still be assisted through reduced user charges or the use of vouchers or subsidies.

Planning privatization

Having considered the options for privatization just discussed, governments may wish to mount a plan for shedding the burden on the state where the public would be better served by the market, while ensuring that they retain the capacity to monitor the performance of the private sector in providing these goods and services. Such a plan is best formulated on the basis of a series of reviews.

To begin with, a review of the private goods being provided by the public sector will shed light on the possibilities for divestiture. Historical factors, such as foreign domination, a nationalist upsurge at the time of independence, and lack of private capital and entrepreneurship may have led the public sector to take on more than it could manage efficiently. If conditions have changed, it may be time for government to divest itself of some of its production activities or to seek management contracts for them from the private sector. Factors such as the emergence of new technologies can also trigger such a review. In more advanced developing countries the computer revolution, and the resurgence of the small firm in the arena of high technology and computerized planning, manufacturing, and control systems, are forces that call for an unusually high degree of innovation, internal flexibility, and adaptability that conventional state control and incentive systems are unlikely to sustain.

A review of the common pool goods and toll goods produced in the public sector will usually suggest some whose production could be franchised or opened up for joint investment or leasing by private entrepreneurs, subject to government regulation. If these activities must remain in the public sector, governments can consider drawing more of the necessary funding from user charges.

A review of the production of public goods may suggest possibilities for subcontracting to private parties. Some public services could be delivered through local governments or nongovernmental agencies on a contract basis. Possibly some services could be produced through cooperative action by the community.

The interests of the poor need to be protected in the process of reform (see box). Doing so may require innovative thinking by planners. Often the lack of access to a public service is a worse problem for the poor than its price. In agricultural credit programs, for example, small and marginal farmers often fail to obtain the adequate and timely loans they need to cultivate their land. To them, access to credit is more important than the subsidies they might receive on interest cost; they are willing to pay the market price provided they can obtain the loan on time.

Conditions for success

If privatization is to succeed, in the sense of raising efficiency or effectiveness in the production or delivery of goods and services, certain conditions must be met.

First, privatization cannot be sustained unless the political leadership is committed to it, and unless it reflects a shift in the preferences of the public arising out of dissatisfaction with the performance of other alternatives. Privatization has in the past worked best when a government was strongly committed to a change, or when a new government vowed to reverse the actions of its predecessors, as has happened in Chile and the United Kingdom. More recently, some governments that have faced severe economic crises, with massive budgetary deficits, have turned to privatization and divestiture as a part of their adjustment strategy.

Second, any alternative institutional arrangements chosen should not stifle competition among suppliers. Replacement of a government monopoly by a private monopoly may not increase public welfare—there must be a multiplicity of private suppliers. This can be a difficult problem where there are few competent suppliers. Though government may wish to contract out a service, if there are only one or two qualified contractors, the benefits of competition are unlikely to follow.

In this context, most developing countries’ systems of regulation need major review and reform. Overregulation of industry discourages private initiative; overregulation of urban land use and building construction retards urban development; and unduly low ceilings on the prices of industrial products and utilities, such as bus transport and electricity, inflate demand and depress the incentives for production.

The third, related, condition is freedom of entry to provide goods and services. Long-term contracts and franchises limit competition and consumers’ choice. In some services that are capital intensive, freedom of entry is difficult to achieve. But in others, such as refuse collection or health services, the public will be better served by several private suppliers competing than by one agency monopolizing the market through a long-term contract.

Privatization and the poor

One of the fears about privatization is that it will hurt the interests of the poor. In societies with an extremely uneven income distribution, it is unlikely that the poor can successfully compete in the market place for goods and services in short supply. What can be done to protect the interests of the poor when a program of privatization is implemented?

• The poor may be willing to pay the market price for private goods and services—for example, agricultural credit or rural health services—provided they have access to them. In most cases, supply at official prices is limited and the poor pay much more than the market price. To improve the access of the poor to such goods and services may require institutional reforms, dissemination of information to the poor, and strengthening of advocacy groups such as nongovernmental organizations.

• Differential pricing may be necessary to enable the poor to consume certain goods. Water taps can be installed in slum areas for the poor to get drinking water free or at a nominal charge, while economic rates are charged for water consumed by high- or middle-income households. Coarse grains consumed largely by the poor can be subsidized, while grains used by higher-income groups are sold at market prices. Cross-subsidization could be used to finance such schemes. In these cases differential pricing need not encourage a diversion of benefits from the poor to the rich. Differential pricing is less likely to work effectively in the sale of agricultural inputs such as fertilizer or seeds.

• If there is an extreme shortage of essential goods such as food or clothing, it may be necessary to provide special coupons or ration cards to the poor to enable them to buy these items at subsidized rates from shops, and for government to reimburse the private suppliers to the extent of the subsidy. Dissemination of information to the beneficiaries, steps to minimize the diversion of benefits to ineligible citizens, and surveillance of the shops by proper authorities are prerequisites for the success of such schemes, which are usually difficult to sustain over extended periods.

Fourth, public services to be provided by the private sector must be specific or have a measurable outcome. Physical construction or utility services, for example, can be measured, but most educational services and police protection are not easy to quantify, even though their inputs can be measured. Lack of specificity makes it more difficult to control services provided by the private sector, especially if the public served is illiterate, unorganized, and unassertive. Service delivery by nongovernmental organizations or local governments may be more appropriate under these conditions.

Fifth, consumers should be able to link the benefits they receive from a service to the costs they pay for it, since they will then shop more wisely for different services. User charges are one way of establishing this link. The importance of educating consumers and disseminating information to the public cannot be overemphasized here.

Sixth, privately provided services should be less susceptible to fraud than government services if they are to be effective. Services provided through collective or cooperative action at the community level are probably the least susceptible to fraud.

Seventh, equity is an important consideration in the delivery of public services. Broadly speaking, the benefits of privatization can accrue to the capital owner who supplies the service; to the consumer, who receives a more efficient service; and to the public at large, through a reduction in the public sector deficit, and hence in taxes or the rate of inflation, or both. Privatization will be counterproductive if the ability of the public to pay, determined by the prevailing income distribution, becomes the sole guide for the delivery of services. And, if the benefits of privatization are likely to be reaped solely by local elites, expatriate groups, or multinational corporations, political resistance to reform is likely to increase.

Conclusion

The foregoing discussion shows that privatization implies much more for the government than just a shrinkage in the public sector. If privatization is to succeed, government must redefine its role to:

• search for ways to increase competition in the supply of public services;

• disseminate information so that consumers can become more rational and discriminating;

• monitor and evaluate the public services being delivered.

Even after some public enterprises have been sold or dismantled, and many services have been contracted out, the public sector’s role in developing countries is likely to remain large. If people have to depend on the government for some services, it is important that they be able to exercise control, directly or indirectly, over the efficiency and effectiveness of the institutional arrangements for such services.

Education for Development

An Analysis of Investment Choices

by George Psacharopoulos and Maureen Woodhall

The authors—who draw upon multidisciplinary resources and the experience of the World Bank and other organizations in lending for education—cover in depth the many broad policy issues implicit in the assessment, evaluation, and analysis of investment choices for education in developing countries.

Issues discussed include:

  • the contribution of education to economic and human development
  • criteria for educational investment
  • cost-benefit analysis and the demand for educated manpower
  • educational finance
  • the internal efficiency and quality of education
  • equity considerations and the links between investment in education and investment in other sectors

Published by Oxford University Press for the World Bank

Essential reading for educators, planners, and policymakers.

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