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There’s Privatization and Then There’s Privatization

by: Dylan DelliSanti
PUBLISHED: 5 December 2011 One Comment

Last week, a Detroit news station ran a story about the dangers of privatization in the foster care business. They interviewed a grandmother who was trying to adopt her grandchildren, but the supposedly “private” adoption agency  refused to let her adopt them. Why? The adoption agency stands to make between $5,000 to $10,000 for in-state adoptions, but only $3,000 for out-of-state adoptions, and the grandmother just happened to live out-of-state. The news station was quick to berate the private adoption agency, accusing them of trying to make a quick buck. The media quickly labeled this situation as a negative effect of privatizing foster care. However, closer inspection into the issue revealed that it is not actually privatization that is at fault here, but a business responding to government, as opposed to market, signals. The adoption agency is not really privatized, it is merely a contracted-out government service.

There is only one method of privatization. We often confuse privatization for “contracting out.” Contracting out involves the government paying a private firm to perform a service.  This contracting out system is used by Michigan’s Department of Human Services (DHS). The DHS contracts out to a private adoption agency and pays them for every child they send to a home. The problem with this system is that government is funded by a constant revenue stream, known as tax revenue. With a constant revenue stream, the government does not have to worry about going out of business. Thus they have little incentive to choose the best and most efficient firm to do business with. Inevitably, the government selects the firm with the most political clout, i.e. the one that will provide them with the most long-term political capital. A firm on contract with the government is not trying to satisfy consumers, but trying to satisfy the government. This is not actually privatization in its purest form.

Actual privatization entails allowing a firm to sink-or-swim, and this is much different than simply contracting out. Under contracting out, a firm does not have to please consumers, because it makes money by maintaining political clout. This is bad for the rest of us, because the firm is not trying to innovate to make a profit. Instead the business is simply trying to keep friendly with the government. On the other hand, under privatization, the firm now has to make a profit and it can only do this by satisfying customers. The firm’s existence literally depends on its effectiveness. If a firm is performing inefficiently, the customers can always choose to do business elsewhere. Consumers have an incentive seek out the best firm, because they do not have a constant revenue stream. Consumers cannot simply point a gun at their neighbors and demand money whenever they wish to purchase something. Thus, consumers will only do business with a firm if that firm is good (if not the best) at its job. On the flip side, producers, in this case adoption agencies, will constantly be trying to innovate to discover the best ways of doing business. This is beneficial for society at-large.

When firms innovate they do so to make our lives easier. For instance, a local newspaper in Chillicothe, Ohio cites one private adoption agency that specializes in finding homes for teens. Finding homes for teens is often a very difficult task that in the past adoption agencies have been unwilling to take up. However, because the firm was working to make a profit instead of pandering to bureaucrats, it had to innovate and provide a service that was often not provided in the past. This example demonstrates how privatization is preferable to contracting out. Under contracting out, firms only pander to small group of people, with a narrow set of goals and preferences. Under privatization, firms have to cater to the demands of many diverse people with various different preferences.

The news station in Detroit made the very common, but dangerous, mistake of confusing contracting out with privatization. The mistake is simple, but the distinction huge. Contracting out is a system filled with cronyism where firms compete to please the narrow interests of bureaucrats and politicians. Privatization is a system that places the power of deciding which firm to use in the hands of consumers. To confuse the two systems as one in the same, and to advocate policies from that premise, will lead to dangerous consequences.

Related posts:

  1. Privatization Will Improve Education
  2. Public System Has Flaws but Privatization Is Not the Solution

One Comment »

  • Treefingers said:

    You’re equating the “free market” model of goods provision with the privatization of public goods and services ; the latter of which regards the transfer of public good and service provision from government to a private entity.

    Given your definition of privatization, a good or service is privatized only when [i] there is perfect and efficient competition in the market for providing the good, [ii] profits are directly and exclusively tied to satisfying consumer demand, and [iii] there is no cost to the consumer to substitute a different goods providers.

    That’s a pretty hard set of criteria to fulfill, especially given that [i] and [iii] are simply false (particularly when it comes to the privatization of public goods), and [ii] excludes publicly-traded for-profit corporations from the definition.

    First off, in theory, public goods are provided by the government because the market fails at efficiently providing the good or service the way a lot of people want it to be/think it should be. The privatization of government services is–again in theory–optimal when (a) the government is unable or finds it too costly to provide the service directly, (b) the good/service is excludable and naturally scarce, and (c) the private provider has a monopoly.

    The truth is, in most cases the privatization of public goods only works if the private entity has a monopoly and/or is government subsidized. The reason is because the private market does not efficiently provide most public goods (it tends to undersupply), so it is necessary for a firm to have a ‘guaranteed’ consumers and profits if it is to provide the good efficiently and sufficiently. That means, in reality, privatization is often mixed up with private companies lobbying legislatures to “privatize” and pass on ridiculously expensive contracts. That’s the reason for the criticism that public service privatization is too often political, inefficient, and corrupt.