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Posts Tagged ‘Profit’

When I give speeches about the economic case for small government, one of my main points is that people in the private sector (workers, investors, managers, entrepreneurs, etc) are motivated by self interest to allocate labor and capital efficiently. To be more specific, the pursuit of higher pay and greater profit will lead people to allocate resources productively.

I freely admit that people in the private sector make mistakes (most new business ventures ultimately fail, for instance), but I explain that’s part of a dynamic process in a market economy. Every success and every mistake leads to feedback, both via the price system and also via profits and losses. All of which leads to continuous changes as people – especially entrepreneurs – seek to better serve the needs and wants of consumers, since that’s how they can increase their income and wealth.

In other words, Adam Smith was right when he said that self interest encourages people to focus on making others better off.

By contrast, when politicians and bureaucrats allocate resources (either directly via spending programs, or indirectly via regulation or tax distortions), feedback mechanisms are very weak. Once politicians intervene, they never seem to care if they are generating positive results. There are plenty of examples, however, of government imposing high costs while producing no benefits. Or even producing harm.

And let’s not forget that “Public Choice” teaches us that interest groups will manipulate government to obtain unearned benefits.

The main lesson from all this information is that it’s good to have small government rather than large government.

But there’s a secondary lesson about how the economic harm of government can be reduced if market forces somehow can be part of the process. And that’s why a new study from two Italian economists at the Centre for Economic and International Studies is worth sharing.

The abstract of the study is a good summary.

We empirically investigate the effect of oversight on contract outcomes in public procurement. In particular, we stress a distinction between public and private oversight: the former is a set of bureaucratic checks enacted by contracting offices, while the latter is carried out by private insurance companies whose money is at stake through so-called surety bonding. We analyze the universe of U.S. federal contracts in the period 2005-2015 and exploit an exogenous variation in the threshold for both sources of oversight, estimating their causal effects on costs and execution time. We find that: (i) public oversight negatively affects outcomes, in particular for less competent buyers; (ii) private oversight has a positive effect on outcomes by affecting both the ex-ante screening of bidders – altering the pool of winning firms – and the ex-post behavior of contractors.

In other words, normal bureaucratic waste, featherbedding, and cost overruns are less likely when the private sector does the oversight.

And here’s an excerpt from the text for those who want more details.

…we propose a distinction between public and private oversight, depending on its source. Public oversight includes all formal checks – cost certifications, pricing data transmission, production surveillance – which the contracting authorities enact during the contract awarding phase and execution. It typically involves considerable paperwork for both the buyer and the sellers. At the cost of some red tape, it is aimed at alleviating the moral hazard problem… On the other hand, private oversight involves third parties – surety companies – issuing bonds (surety bonds) to secure the buyer against unpredictable events. If the seller fails to fulfill contractual tasks, contracting authorities make claims to recover losses. A surety is then called on either to complete the public work by themselves (i.e. with their own resources or by subcontracting) or to refund the authority of the bond value. Being liable in case of unsatisfactory contract outcomes, the sureties have strong incentives both to screen bidders (ex ante) and to monitor contractors (ex post). They help mitigate the asymmetry of information between the buyer and the sellers thanks to their experience of the market – i.e. access to private information – and the screening enacted through price discrimination on premia, which directly affects offers placed by potential contractors. Hence, private oversight enhances the selection of the best contractors and provides a second tier of monitoring of contractors’ progresses.

This is encouraging. It would be nice to have smaller government, but it also would be nice to get the most bang for the buck when the government does spend money.

To be sure, there are probably many parts of government that are impervious to market forces.

But surely there are many ways to protect taxpayers by creating incentives to save money.

  • For instance, on the programmatic level, we can enlist the private sector to fight rampant Medicare and Medicaid fraud by allowing private investigators to keep a slice of any recovered funds.
  • And on the sectoral level, we can achieve big educational gains with school choice, thus giving schools a bottom-line incentive to attract students with better outcomes.
  • Last but not least, we can rely on the competitive impact of federalism to encourage better macroeconomic policy by state and local governments.

The moral of the story, needless to say, is that the private sector does a better job than government. So let’s do what we can to unleash market forces. Be more like Hong Kong and less like Venezuela.

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What’s the most important factor for economic progress?

There are several possible answers to that question. We can take a big-picture view and argue that the key is free markets and small government, and there certainly is lots of evidence in favor of this assertion when you compare countries over time.

But what if we narrow our focus and try to identify, for instance, the key characteristic of a free market. At times, I’ve highlighted the importance of both property rights and the price system.

Private property gives people the right incentives to both produce and conserve, a lesson learned early in American history.

An unfettered price system is a mechanism that best ensures resources are efficiently utilized to serve consumers.

But we need to augment this list by also including the valuable role of the profit motive.

This Prager University video, narrated by my friend Walter Williams, succinctly explains the issue.

I especially like the section where Walter asks what institutions and entities leave us happy and contented. The answer, at least for most of us, is that we’re more likely to be satisfied in our dealing with private companies operating in competitive markets.

That’s because the profit motive gives them an incentive to treat us well, both to boost their reputations and so we’ll be repeat customers.

Simply stated, in a true free market, entrepreneurs, investors, and business owners can only become rich by providing consumers with things that make our lives better.

But our dealings with government (or government-enforced monopolies like cable companies) tend to be less rewarding, whether it’s because bureaucrats are taking our money, bossing us around, or simply treating us poorly.

So the next time some politician or pundit complains about “evil profits,” just remember Walter’s wise words from the video.

P.S. I’ve shared two other videos from Prager University, one of the Laffer Curve and one about statist policies and the Great Depression. They’ve both very much worth watching.

P.P.S. It goes without saying (but I’ll say it anyhow) that profits are only admirable if they’re earned honestly. There are fraudsters in private markets who rip off consumers and there are crony capitalists who use coercive government policies to line their pockets. These groups deserve disdain and punishment.

P.P.P.S. Walter Williams is one of America’s best public intellectuals. I’ve cited his work numerous times, but your first stop, in learning more about him, is this video from Reason TV.

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