Markets and Hierarchies in Public Services: Incentives, Institutions, and Politics

Armando Castelar Pinheiro and Ben Ross Schneider


Governments everywhere face a constant trade-off between providing better and more services to their citizens and keeping taxation and public debt at levels that do not harm economic growth and job creation. Not surprisingly, then, government reformers seek alternative means to provide social services with greater efficiency, better quality, and lower cost than through traditional publicly financed and operated facilities (Joumard et al. 2003). This search often included, since the 1980s, attempts to infuse public administration with the so-called new public management (NPM), which tries to mimic private-sector management practices in the public sector. Examples include the introduction of improved budgeting

We are grateful to the Tinker Foundation for financial support and to Javier Corrales, Tulia Falleti, Jane Gingrich, Karin Gottschall, Luiza Niemeyer and Luisa Azevedo for comments on previous versions. Schneider thanks the Hanse- Wissenschaftskolleg for additional fellowship support.

A. C. Pinheiro (H)

Funda^ao Getulio Vargas, Botafogo, Rio de Janeiro, Brazil

B. R. Schneider

Department of Political Science, Massachusetts Institute of Technology, Cambridge, MA, USA

© The Author(s) 2017 37

G. Perry, R. Angelescu Naqvi, Improving Access and Quality of Public Services in Latin America, Latin American Political Economy,

DOI 10.1057/978-1-137-59344-3_2

techniques, results-oriented management, and performance contracts and bonuses (for a recent review, see Gottschall 2015). But a number of governments went further: several Organisation for Economic Co-operation and Development (OECD) countries, Britain often in the lead, experimented with the adoption of a variety of alternative ‘techniques’ of service provision that incorporated market or quasi-market mechanisms, including contracting out of non-core activities, such as cleaning and security, using vouchers, relying on public-private partnerships to build and operate hospitals, and encouraging competition among schools. Although these alternative mechanisms still account for a small part of the supply of publicly financed social services around the world, their use has steadily expanded and market principles consistently come up in debates on public sector reform (see Le Grand 2007;Gingrich 2011).

The inspiration for the use of such instruments stems from the same conceptual matrix that fed the reform of infrastructure, public utilities, state enterprises, and social security systems, in particular, the goal of separating policy, regulation, and commercial activities, which were previously bundled together under the responsibility of a single public organization. Advocates of this separation argue that, while there are good reasons for governments to be involved in dealing with market failures and pushing for distributive goals in the provision of social services, they do not need to be directly involved in service provision. Thus, reliance on quasi-market mechanisms in social services can be seen as a natural extension of the 1990s market reforms in the economy and the result of the discredit faced by the state as single provider of a wide range of goods and services. It has been this discredit of statist, bureaucratic, and centralized policy options that helped to put in power reformers more predisposed to consider market solutions even in formerly non-market environments, like social services. This continuity also extended to the support of multilateral banks, especially the World Bank and the Inter-American Development Bank (IDB), which have backed the introduction of market mechanisms in sectors previously dominated by public sector providers.1

As was, sometimes belatedly, discovered with the introduction of market reforms in infrastructure, putting these policy recommendations into practice tends to be more difficult in developing countries than in developed countries. Governments in poor countries face a more complex challenge: they have fewer resources but face greater demands to expand the coverage and improve the quality of services. This means that the opportunity cost of public spending, measured, for instance, by the number of lives that may be saved or extended, is higher in poor countries than in rich countries, which in principle would make the use of efficiency-boosting quasi-market mechanisms more attractive. Yet, because most poor countries have less consolidated institutional environments, contracting between the public sector and private parties becomes substantially more complicated and requires special governance structures to operate effectively. Put differently, creating quasi-markets is paradoxically an institution-i ntensive reform. Furthermore, in developing countries, politicians are often less accountable and poor citizens face greater obstacles to effective political participation. The weakness of this ‘long route’ of accountability may in fact increase the attractiveness of shorter, more direct routes of accountability through quasi-markets, though it is not clear how much or how well shorter routes can substitute for the longer routes of formal political accountability.2

Latin America provides a revealing context in which to study the attractiveness and pitfalls of adopting quasi-markets in developing countries.3 The ‘social deficit’ in Latin America, especially in health and education, is enormous, and governments over recent decades have increased spending on those areas. However, more resources alone are unlikely to solve the problem. Indeed, the World Bank (2004) observes that, on average, public spending on health and education is only weakly correlated with outcomes. Thus, without raising the efficiency of public spending and quality of social services, allocating more resources to these sectors will not necessarily translate into better indicators (see also Afonso et al. 2005).4 The three empirical chapters to follow analyze a wide range of reforms in Colombia, Peru, Chile, and Uruguay in service provision, including decentralization and devolved authority, participatory decision-making, voucher systems, and a variety of means intended to improve the flow of information and exercise of accountability. These cases are representative of the many reforms and experiments in government services across the whole region, and this ongoing quest suggests that quasi-markets will remain as options on the reform agenda.

Despite some important exceptions, until recently, research on the use of quasi-markets in the provision of social services in Latin America had been subject to relatively little systematic theoretical and comparative analysis.5 In contrast, the literature on the regulation of public utilities, for example, offers more extensive theoretical elaboration as well as more policy-relevant work on applying theory to different institutional contexts (Levy and Spiller 1996). As in the later literature, our theoretical approach draws heavily on transaction cost economics, principal-agent theory, and the analysis of information asymmetries. In particular, we think there is much to be gained from thinking through problems of multiple principals, perverse or incompatible incentives, and variable costs and quality of information.

Market pressures can be introduced in social service delivery in three general ways: by subjecting providers to competition (1) for funding and contracts or (2) for consumers (e.g., vouchers and other fee for service arrangements), or (3) by promoting internal competition among employees of provider organizations (as in NPM).6 Whereas in normal markets consumers pay directly for what they buy, in social services payment (by governments) and consumption (by citizens) are separate, making these markets partial, constrained, or quasi.7

Each form of competition has distinctive advantages, disadvantages, and information problems. In the first form, competition among providers for funding helps primarily to lower costs. However, providers have incentives to skimp on quality, and the principal (government) has a more difficult time assessing the quality of the services provided, and consumers have difficulties conveying aggregate information on quality back to the government. To mitigate information problems, governments may institute extensive reporting requirements and establish regular testing and other assessment instruments.

In the second form, direct (e.g., vouchers) or indirect (e.g., fee for services) transfers to consumers, who can then choose providers, give consumers (who may have better information on quality) greater leverage over providers, but often increase costs and require greater administrative oversight.8 Since providers compete for consumers, governments may concentrate on generating information on quality and disseminating it to consumers. Voucher systems may also allow for a greater proportion of funds to reach service providers at the front line, rather than being consumed in intermediate administration. Finally, in the third form, competition can be introduced in internal labor markets among healthcare and education professionals and staff. This competition is the mainstay of the NPM generally, and in social services usually takes the form of additional incentives, almost always financial, for better performing employees (pay for performance).9

The goal of this paper is not to assess whether or how much such market mechanisms can improve social services, but rather to develop a framework for analyzing the problems and challenges—in incentives, institutions, and politics—that arise in implementing market reforms. Section 2 summarizes arguments for and against the use of quasi-markets and contrasts markets and hierarchies in social services and public utilities. Section 3 examines complementary considerations—especially facilitating information flows, flexibility, and entry and exit—that impact how well quasi-markets function. Section 4 analyzes potential compensatory measures to redress problems (such as socio-economic sorting, narrowing incentives, and exploiting information asymmetries) that typically arise in using market mechanisms. Section 5 returns to the long and short routes of accountability and considers how quasi-markets can change the politics of social service delivery.

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