Incentives matter in resource allocation

By Frances Coppola

“Rule number one in economics: incentives matter”.

So says Tim Worstall, in this post criticising me for claiming that state investment is not necessarily any less efficient than private sector investment. And he goes on to say that politicians and bureaucrats have different motivations from “profit-mad capitalist bastards” like him.

I don’t disagree in the slightest. But that doesn’t invalidate my argument. 

Tim’s argument essentially is that the profit motive always results in better investments than philanthropic or public service motives. The idea is that people who want to make as much money as possible for themselves will make more efficient use of resources than people who want to help others. But why should the motivation to serve others necessarily make one less concerned about efficient use of resources than the motivation to make money? In short, why should selfishness necessarily ensure better outcomes FOR OTHERS than altruism? 

On the face of it, this seems illogical. If people who work in the public sector genuinely are motivated by the desire to provide the best possible services for others, why would they be any less efficient than private sector actors motivated by the desire to make as much money as possible? There is really only one possible explanation for this, and that is that is that those who work in the public sector are less able than those in the private sector, so are inherently incapable of deploying resources to their best effect. This amounts to saying that selfish people are cleverer than altruistic people. Really?

I suppose it is possible that the dim-witted self-select to work in public service, and are never weeded out because, er, their managers are dim too, but to me this seems rather far-fetched. So what other reasons might there be for inefficiency in public service? There are a number of possibilities. 

The first is that those who work in public service actually aren’t genuinely motivated by altruism. And this is indeed possible. But is someone necessarily less efficient because they get their rewards in non-monetary forms – whether personal recognition, the satisfaction of a job well done, or the warm feeling that comes from seeing the lives of others made more comfortable? Or is someone necessarily less efficient because they are motivated by the desire to work locally, have a secure job and earn a comfortable living? Again, this looks far-fetched. 

Some claim that that anyone who works in public service – and in particular, anyone who goes into politics – is doing so because they expect to benefit personally and not out of any genuine public service motive. At its most extreme, this amounts to saying that all politicians and bureaucrats are corrupt. Some are, for sure – but all of them? This is not remotely supported by the evidence. The UK’s record on corruption is rather good, actually. No, if there is waste and inefficiency, it doesn’t stem from corruption. 

But it might stem from bureaucracy. Indeed there is a strong argument that the natural tendency of  managers in the public sector to build empires increases bureaucracy at the expense of efficiency. The public sector is not homogenous, but it is very large, and size and bureaucracy definitely go together. But the same argument can be made about any large organisation, private or public sector. The profit motive is no stronger for the thousands of employees of say, Barclays, than it is for the thousands of employees of Her Majesty’s Government: they are all simply doing jobs for wages. But the empire-building incentive is at least as strong. It is illogical to assume that a private sector firm of a similar size to a public sector organisation is more efficient simply because it is in the private sector. And it isn’t supported by the evidence, either. Large commercial organisations can be astonishingly wasteful. I have never seen so much money wasted in my life as I did in the finance department of Midland Bank. Though admittedly, Midland suffered the fate of large inefficient commercial organisations – it was taken over. Which brings me to the next criticism of the public sector: lack of competition. 

The story goes that private sector actors make efficient use of resources because otherwise they will be forced out of business by more efficient players. So a public sector organisation that has no competition will inevitably become inefficient, simply because it lacks the discipline of competition. 

But the discipline on the public sector is the democratic vote. Politicians that have presided over profligate spending programs can be voted out of office, and politicians can be elected on a cost-cutting mandate. Indeed successive governments, of both colours, have pursued the objective of “eliminating waste” in the public sector, cutting costs, privatizing functions and outsourcing services at an astonishing rate. The belief that profit motivation ensures efficiency has been the driving force behind public sector reforms for the last thirty years. 

As a consequence, there is now significant competition in the public sector. Both central government and local put out services for competitive tender: these are fought over fiercely by a mixture of profit-making and non-profit-making providers, and it is not always the profit-makers who win. Nor is competitive tendering the only source of competition in the public sector. Failing schools are taken over by other schools in much the same way as failing companies are taken over by their competitors. Failing hospitals are heading the same way. Yes, it seems brutal: but it is a necessary discipline on the public sector. 

The growth of competition in the provision of public services is actually as much a discipline on the private sector as the public sector. This is because the need to make a profit is itself an inefficiency*. Public services are not necessarily provided by either the public sector or the private sector: the non-profit-making sector (the “third sector”) is an immensely important provider of public services. If there is competition between profit-making and non-profit-making providers, the non-profit-makers should always win. If they don’t, it could be due to bureaucratic inefficiency. Or it could be due to other factors. 

Organisations that provide a public service may additionally have other goals, such as paying living wages to their employees. This is no doubt what is behind Tim’s suggestion that profit-making organisations would pay lower wages. The public sector is often criticised for high pay rates and gold-plated benefits, which is to some degree true, probably because unions have more power than in other sectors. But we do have to be a little careful with comparisons: the public sector has a high proportion of highly-qualified employees who would command good salaries in the private sector too. Most low-skill, low paid public sector jobs have long since been outsourced. 

But the third sector is an entirely different matter. It really can’t be regarded as profligate with pay. In fact it can be astonishingly mean. Pay rates in the third sector are generally far below rates for equivalent jobs in the private or public sector: many charities would rather not pay their workers at all, let alone living wages. When I worked for a charity bank, I had to remind the directors that expecting to pay well below market rates simply because they were a charity did not help them to recruit or retain good staff. The existence of highly efficient non-profit-making organisations whose directors and staff are motivated by the desire to provide a good service is compelling evidence that Tim’s argument is fundamentally wrong. Incentives do indeed matter, but the profit motive is no better an incentive than the desire to do some good.  

Tim comments that politicians may be more interested in creating jobs than providing efficient, low-cost public services. And Simon Cooke (a local politician in Bradford), in a comment on Tim’s post, observes that: 

“The problem here, such as it is a problem, is that those “social motives” that define the objectives of state investment are ill-defined. For sure, we can look at the NHS and describe its objective as improving the health of the population, we can even quantify that objective (increased life expectancy, for example) but there is no incentive to see that objective as paramount. The result is mission creep…..

“Within the public sector decisions are compromised by this mission creep – be it environmental, ‘equalities’ or some other ‘social purpose’ that really has nothing at all to do with the real purpose of the institution. The classic examples is jobs – I was castigated at one meeting for saying that if we could run Bradford Council’s services without needing to employ a single person then, ceteris paribus, this would be a good thing – for the service and for the taxpayers who fund the service.”

Here is the heart of the matter. It is not the motivation to make money that makes people efficient with resources. It is having a single clearly-defined purpose. 

When objectives are unclear, money is inevitably wasted. This is true in the private sector as much as the public sector. In the private sector, organisations that have no clear purpose eventually go out of business (Woolworth’s springs to mind). In the non-profit-making sector, organisations that have no clear purpose never get off the ground – after all, who is going to give to a charity that has no clear idea what it will do with the money? And in the public sector, organisations that have no clear purpose are (we hope) eventually eliminated by politicians acting in accordance with their democratic mandate.  

Those who claim that the public sector is intrinsically inefficient and corrupt, so should be cut to the bone or, preferably, dismantled completely, are therefore doing us all a favour. Their disapproval provides the discipline for the public sector that competition provides in the private sector. And because of it, there is much less difference between the efficiency of the public and the private sectors than they think. So they are wrong, but – perversely – we need them to continue to believe that they are right.

By the way, the debate in the comments on Tim’s post was one of the most interesting and good-natured online debates I have ever taken part in. I do recommend reading it. It develops the argument about bureaucracy and perverse incentives in the public and private sectors quite a bit, and concludes that actually it can be very hard to tell the difference between the public and private sectors.  

Related reading:

Public choice theory – EconLib

* Perfect competition forces down profits to zero. If costs are the same, therefore, a company that doesn’t need to make a profit will always outbid one that does need to make a profit. The profit-maker’s attempt to make a profit by cutting costs will be undermined by the non-profit-maker doing the same. The profit motive in the provision of public services therefore to some degree creates inefficiency.

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