What Causes the Relative Inefficiency of the Public Sector?

Private organisations die when they run out of money. Public organisations don’t need to worry about running out of money directly. When considering their behaviour and efficiency, is there a more important difference between them? I suggest that any observed differences in efficiency may be due only to survivorship bias, rather than superior management.

According to Coase‘s The Nature of the Firm, commercial organisations arise when transaction costs in the open market exceed co-ordination costs in a firm. Anyone who’s ever worked in a large organisation will know that those co-ordination costs are high. When considering the inefficiencies in some places I have worked, I was sometimes surprised by the size of the profits that those firms made. Clearly, the inefficiencies in those firms were not big enough to stop them from being very profitable.

Despite my surprise at these inefficiencies, though, the sample I have seen has been strongly biased. I have never worked in the public sector, and I have mostly worked for FTSE 250 or bigger firms. If we imagine that internal inefficiencies can get worse, one possible result is that afflicted firms lose profitability. Complete loss of profitability eventually leads to bankruptcy or take-over.  Large firms should perceive a huge incentive to cap co-ordination costs: they can die if they don’t. But even if that incentive didn’t cause any action, though, we still shouldn’t expect to see many large firms with unusually high co-ordination costs. After all, if those costs grow out of control, then the firm will cease to exist.

So survivorship bias means that the inefficiencies in large firms are not likely to be as bad as they could be, because deeply inefficient firms shrink and go out of business. The same may not be true of public sector organisations.

Public sector organisations have money flow in and out of them, but they cannot be said to be profitable in the same way as private firms. They may have a budget surplus, but this is not a profit. There may be measures of their effectiveness, but the government has discretion over their budget. Perceived poor performance one year does not necessarily mean a lower budget next year. Provided that the government will fund it, a public sector body’s costs can rise indefinitely; governments can have enormous budgets.

Many people complain about wasteful government expenditure, and wish that the public sector was as efficient as the private sector (although I cannot recall concrete measurements ever being given). There’s a suggestion that the private sector is inherently more disciplined.

We might infer that there is some managerial or even moral superiority present in the private sector, which does not tolerate inefficiency. But perhaps private sector management is not better at rooting out inefficiency than the public sector. Couldn’t it just be market forces that eventually do that? Then any difference between inefficiencies in the public and private sectors could be due to the higher survivability of inefficient public sector organisations.

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