| STEVE H. HANKE | Steve H. HANKE |
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CONTRIBUTING EDITOR Professor of Applied Economics at the Johns Hopkins University & Columnist at Forbes magazine |
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A private infrastructure solution |
Poor infrastructure not only increases costs but can literally bring an economy to its knees. Turkey and many other developing nations have been handicapped by poor infrastructure. In the U.S. and elsewhere, investments in infrastructure and its maintenance are projected to be enormous. Indeed, for the Europe and Central Asia region, a recent World Bank study projects expenditures for infrastructure investments and maintenance in the 2005-2010 period to account for seven percent of GDP. A critical question that must be addressed is: Should the infrastructure be provided by the private or public sector? Adam Smith answered this question in the Wealth of Nations (1776). He concluded that “No two characters seem more inconsistent than those of trader and sovereign” since people are more wasteful with the wealth of others than with their own. He thought public ownership and administration were negligent and wasteful because public employees do not have a direct interest in the commercial outcome of their actions.
Comparative cost analyses of private versus public provision of goods and services give support to the conclusion that private firms are more cost-effective than public firms. Considerable evidence suggests that the public cost incurred in providing a given quantity and quality of output is about twice as great as private provision. This result occurs with such frequency that it has given rise to a rule-of-thumb: “the bureaucratic rule of two.”
With the private provision of infrastructure, however, there is a potential problem: introducing and maintaining competition. This potential problem can arise because of the so-called natural monopoly character of many infrastructure projects. In short, even if there are no artificial barriers to entry, a monopoly will likely emerge because a single firm can produce goods and services more cheaply than multiple firms could. But there is a way to solve the natural monopoly problem and introduce competition into the provision of private infrastructure. It involves a system of competitive bidding for privately-owned infrastructure franchises. Though competition within a market may be impossible, the benefits of competition for that market may be attainable.
The key to the franchise bidding approach to natural monopolies is the following: bidding for the monopoly franchise should not be in terms of a sum to be paid for the franchise, but in terms of the prices that the franchisee would charge and the services the franchise would provide the public.
Because it may be difficult to select a winning bidder, specify or renegotiate contracts, and police the contract, there must be some sort of “buyers’ agency” to represent consumers. These buyers’ agents must be well-rewarded for monitoring the terms of the franchise contract.
The benefits of such a private system would be considerable. Giving the winning bidder a monopoly franchise will ensure that the firm is able to exploit all possible economies of scale in the provision of service, while requiring bidders to compete on price and service standards will prevent the firm from using its market power to overcharge or underprovide. Granting this monopoly franchise to private owners will harness the incentives of these owners to control costs efficiently in order to maximize profits.
To implement the system, the government need only create such a buyers’ agency with a mandate to conduct the auction and devise the contracts for the construction, maintenance, or operation of the facilities. Once the franchise is granted, enforcement of the contract can itself be privatized (though France provides evidence that highly paid civil servants can perform this task effectively). An accounting firm, for example, could be retained to audit the franchise and confirm that the terms of the contract have been observed. To create additional incentives for franchisees to maintain and improve quality, contracts could require the franchisee to post a bond for the duration of the franchise. This bond would be forfeited to the contract enforcers if the franchisee is found to be in violation of the contract; it would serve essentially the same function as a “security deposit” on an apartment.
Once in place, the franchisee will have every incentive to aggressively control costs, adopt new technologies, etc., since every dollar of cost saved is an extra dollar of profit earned. If the firm’s managers are not attentive to cost control, the firms’ profits will fall, share prices will decline, and the firm will become a ripe target for acquisition.
Most nations face daunting infrastructure problems. To solve them, well-tested methods of private provision must be embraced. Private infrastructure franchises that are properly designed and strictly policed hold the key for infrastructure provision.
