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Privatization: Maybe good, maybe bad, definitely ugly

Steve Tadelis, professor of business, economics and public policy | April 3, 2011

New York’s deputy mayor, Stephen Goldsmith, a champion of privatization, announced plans to “insource” tasks and services that the city previously privatized and assigned to contractors and consultants, citing opportunities to save money for the city. Isn’t saving money the motivation behind recent plans by Florida’s Republican leaders to privatize prisons and probation services? Governor Tom Corbett of Pennsylvania, likewise, announced earlier this month that he will study the benefits of privatizing state owned liquor stores. But he said that it “isn’t about the money. It’s about the principle. Government should no more run the liquor stores than it should run the pharmacies and gas stations.”  What, then, should governments be providing, and does privatization actually save money or inflate expenses? The answer is, it depends.

There are services that have been proven easy to privatize, such as garbage collection. The task is simple and well defined: drive the truck, pick up the cans, dump the trash and don’t spill it on the street.  How do we ensure high quality service? Citizens will complain if it isn’t.

But not everything that seems straightforward is easy to privatize.  Take information-technology (IT) services. There are dozens, if not hundreds of private companies that provide a variety of IT services, making it easy to find qualified private providers who can bid for, and supply, IT services. But for governments to use the market mechanism, they have to specify in advance what services are needed, how they will be delivered, how success will be confirmed, and how payments will be made. What makes IT services challenging is the rapid change in the ways we use IT and in the technologies that are used to deliver it.

Not long ago I heard a telling story from a city manager in California. Some city council members suggested that there is no reason to have an in-house IT department when there are so many excellent private companies that do the same thing. Shortly thereafter, they hired a private firm at a price that was significantly less than their costs of having an in-house team. Things went great until the first time they asked the company to produce a new report. The company’s response was “that’s not in the contract and we will have to charge an extra fee.” This made sense. The problem was that every few weeks a new report or a new analysis was needed for some ongoing activity, leading to a succession of change order requests with extra payments.

Since the company owned the database, the city could not get competitive bids for new changes. Within months, the city had to hire a part-time employee to deal with change orders.  After a couple of years it was clear that the city was paying more than double for the same quality of IT services they previously received from their former in-house staff. When the two year contract was up for renewal, they terminated the contract and brought back an in-house team.

This kind of problem is not exclusive to local governments. Big corporations can fall into the same trap. In 2004, Sears, Roebuck and Co. outsourced its IT services to Computer Sciences Corp (CSC). After less than a year, Sears terminated the $1.6 billion 10-year agreement with CSC and brought the services back in-house. In 2002 Diebold outsourced its IT services to Deloitte with a 7-year contract in place. In 2006 Diebold backed out of the contract 3 years early and brought back 80 workers to provide the services in-house. More recently, in July, 2009 Boeing acquired one of its most important contactors, Vought Industries, to achieve better control over the much delayed production process of Boeing’s 787 Dreamliner.

At the heart of these problems lies a conflict of interest that is present in any outsourcing or privatization relationship. The buyer, or city, seeks to provide a service at lower costs compared to in-house provision. On the other hand, the contractor wants to make a profit. This tension means that the relationship must be designed carefully in order to ensure a successful outcome for both local government and private contractor. If the service that is outsourced or privatized is difficult to scope, define, bound or monitor, then what the government may seek and what the contractor delivers are neither aligned nor easily described. This leads to an imperfect contract for which neither party’s expectations are adequately accounted for. Costs can skyrocket due to change orders. In a public procurement setting where there are no immediate market pressures to control costs, this can lead to long lasting waste. Furthermore, if the service requires adaptation as the relationship evolves, then the flexibility a government would have with its own workforce is lost.

Politicians like simple messages.  The trouble is that political agendas seldom align with the cost-benefit analysis required for good privatization policy decisions. The tough part is strategically choosing the right projects and services for privatization that have a good chance of avoiding outsourcing’s pitfalls.

Politicians like simple messages. Conservatives like to say that “privatization provides good services at low costs,” while many liberals will claim that “privatization reduces quality and costs jobs.” Both can be right or wrong, depending on the particulars of the service involved. The ugly part is that political agendas seldom align with the cost-benefit analysis required for good privatization decisions. An operational framework for strategically choosing whether or not to privatize a given service requires an ability to identify both the opportunities from privatization and its potential pitfalls. We can only hope that Mr. Goldsmith has some people who can do it for the benefit of New York’s citizens.

Comments to “Privatization: Maybe good, maybe bad, definitely ugly

  1. Steve helpful article am a COP in Australia and was good for my masters assignment on NPM. Thanks kind regards Steve.

  2. I wonder if these entities who, after out-sourcing, in-sourced these functions again actually saw these adventures as failures? They dismantled programs/departments and I can imagine that they brought in new staff at lower wages, fewer benefits, etc. in a new labor environment. Thus, these experiments in out-sourcing can still be beneficial (to the bottom line) when they fail by undermining salaries, etc. So that’s another incentive for irresponsible outsourcing.

  3. Back in the mid-1970s I remember the debate over privatizing commercial trash collection in New York City, except they didn’t call it privatizing back then. I remember a friend of the family was against it. “The family is going to take it over”, he said. “The family”, I asked. “Organized crime”, he explained. I was just a kid back then.

    He was exactly right. The mob moved in. Prices were fixed. Territories were fixed. That was privatization. Businesses had to buy trash removal, and many of them had lobbied for privatization in hopes of saving money, so they were stuck. It took some serious government spending on investigation, prosecution and imprisonment to get the mob out. (One undercover cop playing a building manager did such a good job, the building hired him a few years later when he retired from the force.)

    I’m not saying privatization can’t work. I was against the Vietnam War and felt that the Soviet threat was overstated. I would have been glad to have bought just the military protection I needed without government meddling in the free market. Despite this, I think privatization is overrated.

    By the way. In the private sector, they call privatization outsourcing, and it isn’t all it is cracked up to be there either. Look at all the quality control problems companies face when they outsource to China. Look at Boeing losing its ass when it privatized components of the Boeing 777. You can go down the list. Sure, you don’t want to do everything, but there are big chunks of one’s core business that one privatizes at one’s peril.

  4. Thank goodness for a voice of sanity in the politicized cacophony. Tadelis has my vote! I only wish it were easier to win elections with an honest, if not decisive message of, “it depends.”

  5. referencing easy example “such as garbage collection, the task is simple and well defined, drive the truck, pick up the cans, dump the trash and don’t it on the street” unfortunately in some locations controlled by ‘spillcontrôlée par la foule’ or perhaps it’s a perfect example of privatization

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