Sunday 9 December 2007

How Laissez Faire was Adam Smith?

Gavin Kennedy at Adam Smith's Lost Legacy sets about answering this question. Kennedy writes:
"Adam Smith did not recommend laissez faire economics, though he had many opportunities to do so. He doesn't mention laissez faire (leave alone; or ‘laissez nous faire’, leave us alone', in its original format) in Wealth of Nations, nor in anything else he wrote, including his correspondence." ...

"To the generally accepted roles for government, Smith added others of a more controversial nature. For some, it is an issue of fundamental principle; for others it is a boundary dispute. Among these issues Smith identified:

● The Navigation Acts, blessed by Smith under the assertion that ‘defence, however, is of much more importance than opulence’;
● Punishment and enforcement after acts of dishonesty, violence, and fraud;
● Sterling marks on plate and stamps upon linen and woollen cloth
● Enforcement of contracts by a system of justice;
● Wages to be paid in money, not goods;
● Regulations of paper money in banking;
● Obligations to build party wars to prevent the spread of fire;
● Rights of farmers to send farm produce to the best market (except ‘only in the most urgent necessity’);
● Premiums and other encouragements to advance the linen and woollen industries’;
● Police or preservation of the ‘cleanliness of roads, streets, and to prevent the bad effects of corruption and putrifying substances’;
● ensuring the ‘cheapness or plenty [of provisions]’;
● patrols by town guards, fire fighters and of other hazardous accidents;
● Erecting and maintaining certain public works and public institutions intended to facilitate commerce (roads, bridges, canals and harbours);
● Coinage and the Mint;
● Post office;
● Regulation of institutions, i.e., company structures (joint stock companies; co-partneries, regulated companies);
● Temporary monopolies, including copyright, patents, if fixed duration;
● Education of youth (publicly funded ‘village schools’, curriculum design,);
● Education of people of all ages (tythes or land tax)
● Encouragement of ‘the frequency and gaiety of publick diversions’:
● The prevention of ‘leprosy or any other loathsome and offensive disease’ from spreading among the population;
● Encouragement of martial exercises;
● Registration of mortgages for land, houses, and boats over two tons;
● Government restrictions on interest for borrowing (usury laws) to overcome investor ‘stupidity’;
● Limiting ‘free exportation of corn’ only ‘in cases of the most urgent necessity’ (‘dearth’ turning into ‘famine’)
● Moderate export taxes on wool exports for government revenue"
This does raise the interesting question of where the boundary between public and private enterprise should be. In the modern literature one paper to address this issue is Hart, Oliver D., Shleifer, Andrei and Vishny, Robert W. (1997). 'The Proper Scope of Government: Theory and an Application to Prisons'. "Quarterly Journal of Economics", 112(4) November: 1127-61. The HSV model considers the choice between in-house production and contracting out. The provider, government or private, can invest in improving the quality of service or reducing cost. Given incomplete contracts, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee has. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on noncontractible quality. Cost are always lower under private ownership but quality may be higher or lower under a private owner.

Hence the focus of the HSV model is on quality. Here quality has a broad interpretation. It can stand for how well prisons treat prisoners, how clean utilities keep the water, how well schools educate their pupils, how long it takes for a letter to reach a remote area or how innovative car makers are etc. The basic idea is that the provider of the service, whether it be the government or a private firm, can made an investment to increase the quality of the service or a investment to reduce the cost of the service. It is important to note that quality is reduced by any cost reductions. Neither of these two investments are ex ante contractible. But to implement either of the innovations requires the agreement of the owner of asset. The asset can be thought of as, say, a school or a hospital or a prison. If the owner of the asset is the government then the provider of the service, who will be a government employee, requires the approval of the government to invoke either investment since, in this case, the residual control rights reside with the government. As a result, the employee will receive just a fraction of the returns to either innovation, even if implemented.

If on the other hand the provider is a private sector contractor, then the contractor has the residual control rights and thus does not need the government's agreement for a cost reduction. However, if the contractor wishes to improve the quality of the service and receive a higher price for it, then they have to renegotiate with the government since the government is the purchaser of the service. Under the assumption that the contractor is successful in obtaining an increase in price they capture all such gains. Thus a private contractor will generally face stronger incentives, than a government employee, to improve quality and reduce costs but the incentive to reduce costs can be too strong since the contractor ignores the negative impact this has on quality.

HSV examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Their theoretical arguments suggest that the case for in-house provision is generally stronger when noncontractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatization is stronger when quality reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government. They then apply this analysis to several government activities using the available evidence on the importance of various factors. They conclude that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for privatization is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools.

For all this fancy technical modelling we do, however, have to ask, are really any further advanced on this issue than Adam Smith was.

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