1. The Role of Competition in Bureaucracy Benito ARRUÑADA http://www.econ.upf.es/~arrunada http://www.econ.upf.es/~arrunada Pompeu Fabra University

2. Introduction: Organizational divisionalization

3. 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

4. Key issue Moving away from bureaucracy (expense centers) to “internal markets” or, at least, introducing market incentives in bureaucracies

5. 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.

7. Three Parts ▪ I. The economics of bureaucracyThe economics of bureaucracy ▪ II. Learning from old servicesLearning from old services ▪ III. Taking stockTaking stock

8. Part I The economics of bureaucracy

9. 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

10. Discretionary expense center with increasing cost function

11. The equilibria of a bureaucracy: Niskanen’s model ▪ Maximize budget for two demand functions, D1(Q) and D2(Q) subject to total utility >= budget

12. Production under competition, monopoly and bureaucracy

13. 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

15. Does cost allocation have any effect? ▪ Joint costs imputed according to cost “drivers” ♦E.g., heating costs allocated proportionally to surface ▪ Usually not seen as “prices” but trigger similar incentives: ♦Possible cost consciousness (Zimmerman) ♦Distortions: e.g., surface  excessive height; direct labor  excessive capital intensity; similar to taxing windows, narrow dark houses… ▪ “Activity Based Costing” (ABC) = chose the right drivers (easy to say!) and minimize product variety

16. 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

17. 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)

18. 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?

19. 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

20. 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?

21. Part II Learning from old services Judiciary Registers Schools

22. 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

23. 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

24. 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

25. Part III Taking stock

26. 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

27. 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

28. 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