The Role of Competition in Bureaucracy

Benito ARRUÑADAhttp://www.econ.upf.es/~arrunada

Pompeu Fabra University

Introduction:Organizational divisionalization

Possibilities and problems

▪ Divisions without objective evaluation ♦ Expense center—budgets (bureaucracy)

▪ Divisions with objective evaluation♦ Cost center

• Quality suffers

• Too little/much quantity, with increasing / decreasing costs

♦ Revenue center: excessive quantity♦ Profit center

• Transfer pricing: congruency versus motivation

♦ Investment center: • Be careful with ROI Use residual profits

Key issue

Moving away from bureaucracy (expense centers) to “internal markets”

or, at least, introducing market incentives in bureaucracies

Family doctors are being asked to get a grip on hospital spending. It is a tough battle

“The National Health Service: The power game”, The Economist, March 3, 2007, pp. 33-34.

Three Parts

▪ I. The economics of bureaucracy

▪ II. Learning from old services

▪ III. Taking stock

Part IThe economics of bureaucracy

Expense centers

▪ Given a budget, provide vague set of services♦ In firms: accounting, personnel, planning departments♦ Ministries, universities, Government, NHS, etc.

▪ Problems: grow to large & inefficient b/c:♦ Users not pay demand until U’ = 0♦ Providers “build empires”

• to consume, career, prestige, hire friends, etc.

♦ Budget office badly informed on users’ value and providers’ costs: • E.g., spend annual budget fully to avoid hinting of slack

Internal Demand

Cost

Marginal Cost

Average Cost

Quantity

Tendency

Optimal budget

Discretionary expense center with increasing

cost function

The equilibria of a bureaucracy: Niskanen’s model

▪ Maximize budget for two demand functions, D1(Q) and D2(Q) subject to total utility >= budget

D (Q)2

D (Q)1

j

s

o

D, C

k

Q

g

i

hl

a 2

f

(óptimo)Q* 1a / b

Q = 2(a -s)÷(b+t)1 1 Q = a /b22

a1

2(a -s)÷(b+t)2

C (Q) = s + tQmg

mg

Production under competition, monopoly and bureaucracy

Competition

Monopoly Bureaucracy

Internal Demand

Marginal Cost

Budget battles, cuts, freezes

▪ Budget office does not know where to cut

▪ Gaming with budget office: e.g., closing service to crucial, sensitive clients

▪ Root causes subsist recidivism

▪ Even “zero-base” budgeting not much better than usual “incremental” budgeting

Radical solution: incentives, even aiming for an “internal market”

▪ Users: prices (partial, total) and/or opportunity cost through freedom of choice (among expenses, internal providers, external providers)

▪ Providers: pay for performance, even profit sharing; and freedom to organize provision

▪ Budget office: upgraded to market designer and manager, big expense center itself

▪ Hope-for effects♦ Users reveal information better control of budget♦ Providers organize efficiently♦ Users guide resource allocation, closures efficiency

How markets work

▪ Real markets rely on property rights, which automatically♦ Evaluate performance♦ Reward owners♦ Reallocate resources

▪ Artificial markets need a planner to♦ Allocate decision rights♦ Design and implement evaluation systems♦ Reward decision makers who are not owners

(agency)

The market planner’s tasks ▪ Designing the market

♦ Allocate decision rights♦ Design and implement evaluation systems♦ Reward decision makers who are not owners

(agency)

▪ Avoiding market failure♦ Externalities: More than in real markets?♦ Locus of uncertainty

▪ Tolerating market decisions♦ If we are reluctant to close private firms, are we

willing to accept the market’s verdict on public services?

Jensen’s “locus of uncertainty” problem

▪ Matching supply and demand to avoid parties’ freedom causing surplus capacity

▪ Factors: ♦ Expense composition affects consumption

predictability♦ Computers help real time budgeting♦ Capacity to speedy re-contracting of recourses ♦ Flexibility for internal reallocation of recourses

Discussion

▪ The Lenin-Lange paradox♦ Does it make sense to nationalize an industry (e.g.

healthcare) to later create an internal market?• Only as a stepping stone for privatization?

▪ If the internal market is a planner’s fantasy, what should be done with public services?

Part IILearning from old services

Judiciary

Registers

Schools

Judiciary

▪ Users pay fee for service

▪ Judges paid fixed salary quality

▪ Judicial clerks paid salary plus share of fees speed, quantity

▪ Mutual control of judges & clerks

▪ Planners:♦ Suppressed variable compensation of clerks in the 1950s♦ Suppressed fees in 1986

▪ Increasing judicial congestion productivity bonus for judges quality disregarded, mostly ineffective

Registries

▪ Users free to choose notaries, pay fees▪ Mutual control

♦ Notaries with closed number, franchisees, local competition♦ Registrars with closed number, franchisees, territorial

monopoly

▪ Vertical control♦ Counsels (Letrados) with inspection & appeal functions, paid

fixed salary + substantial deferred compensation

▪ Planners♦ Suppressed counsels♦ Wanted to introduce free choice of registrars♦ Ended up mandating maximum delays

Schools

▪ Basis for internal market in place: private and public schools, money following users

▪ When demography down, demand switched towards private schools

▪ 17 Planners decided against the market:♦ Constraints on users’ choice ♦ Constraints on private schools growth

▪ Private schools’ dropping to public standards

Part IIITaking stock

Salient features of old services

▪ Automatic management: ♦ Opposing incentives: fixed vs variable for controller / controlled

▪ Partial but strong incentives♦ Judges & Letrados: quality important long term careers,

deferred compensation♦ Secretaries: pushing papers, variable compensation ♦ Notaries: Franchises cost containment♦ Registrars: intermediate:

• quality & externalities important monopoly

• Franchises cost containment

♦ Notaries & Registrars: property rights: e.g., employers

Contrast with internal markets

▪ Plenty of management in designing & running the system

▪ Comprehensive incentive system, trying to cover many dimensions of performance, ideally measured with profit or even ROI proxies

▪ Weak incentives♦ Incomplete decision rights♦ Small variable compensation as % of total♦ Profits or savings not individually appropriated but

invested in unit

Tentative conclusions

▪ Internal markets♦ Costly to implement♦ Produce little value:

• Weak incentives

• market decisions are rejected

▪ Options for public services♦ Real markets, perhaps with public financing♦ Bureaucracy

• With automatic management elements: e.g., public hospitals run by fixed salary, deferred compensation managers and pay for performance doctors

• With minimalist planning units