Incentives include rewards such as bonuses or promotion for success, and penalties such as demotion or dismissal for failure to act in the principles interest. (Black, J. 2003). The actions however, may not always be apparent so it is not usually adequate for the principle to state payment on the actions of the agents. The reasons why we expect the public sector to be inefficient has to do with the incentives and restrictions of the individual and organisational levels. There are at least two important reasons why perfect contingency markets have not developed as stated by Broadway & Wildasin (1984).
The first reason is that the transaction costs of establishing such markets might be high relative to the number of traders. The other reason is the observable fact of asymmetric information, also known as the principal agent problem. Two particularly significant consequences of this reliance are moral hazard and adverse selection. Daniel W. Bromley (1989), states that the principal must rely on indicators of success rather than success itself (adverse selection), while the agent directs attention toward the satisfaction of proxy measures rather than toward the success of the task itself. (moral hazard).
The hazard in moral hazard refers to the fact that the individual has an incentive to direct behaviour toward proxy measures rather than toward the desired goal. This redirection can result in creating incentives for perverse behaviour. The adverse in adverse selection refers to the fact that the establishment of monitoring criteria leads to perverse measurement. Individuals who wish to take out insurance possess information that insurers dont. The insured persons (the agents) can exploit this informational advantage in dealing with insurers (the principles) in various ways (Broadway & Wildasin, 1984).
Moral hazard occurs when the insured can, through actions unobservable to the insurer, influence wither the probability of a loss occurring, or the magnitude of the loss. For example, a person can influence the probability of an accident by the degree of preventive action taken. If the quantity of preventive action is not observable to the insured, market failure can result. Alternatively the standard example of how the insured influences the size of the loss is medical insurance. In the event that illness occurs, the insured can overuse medical services.
Adverse selection occurs when there are several different types of insured persons, distinguishing from one another by the probabilities of a bad state of nature occurring. Thus, for some persons might be high risk and others low risk, and the insurers cannot tell one from the other. Automobile insurers cannot tell careful from careless drivers except imperfectly through such indicators as sex, and family status. Equilibrium may not exist in the presence of adverse selection and even if it does it may not be efficient.
A problem related to adverse selection is the simple lack of information by market participants. The diversification of the Pareto-Optimality of competitive markets assumed that individuals and firms have complete knowledge regarding the availability and attributes of all goods and factors. Such will not always be the case. Consumers may not know the implications of various products for their health or safety, nor will they have full information on the relative merits of various competing consumer items.
Firms do not always know the quality of the labour force they are hiring. The provision of information has the attributes of a public good, especially the joint consumption property. Thus, information on product safety and health hazards is often publicly provided. (e. g the Food and Drug Administration). Similarly the education system provides, in addition to its training role, an informational function known as screening.
That is by attaching levels of achievement to persons coming out of the education system (e. g. egrees, diplomas, grades), information is being provided to prospective employers regarding the potential productivity of the person. Presumably, the practice of licensing various professions or trades plays a similar screening role, however imperfect it is. The dissemination of information can, for our purposes, be considered as a particular type of public good. Due to the non existence of perfect contingency markets, Pareto optimality does not exist in the real world, and this may influence government behaviour.
According to Brown & Jackson (1990), inefficiency in the public sector arises when there is an asymmetry of information between those who demand services and those who supply them. This problem is predominantly evident in education and healthcare due to imperfect information. For instance, a patient (the principle) seeks information and advice from her GP or consultant (the agent) concerning her medical condition (i. e. health status). The doctor has specialist technical knowledge and subsequently in providing information to the patient the doctor also advises them on what should be done next.
Therefore, because the doctor has the technical skills to make decisions in the patients best interests; in most cases they make the decisions for the patients. Had the patient been fully informed and competent enough to assess the technical options, the doctor wouldnt have to stand in place of the patient as they would have been able to make their own decisions. The public sector consists of professional groups such as doctors, lawyers, teachers, planners etc. Each of these professions holds their own norms and standards that have a hold upon the level and quality of their services.
If a lawyer puts professional standards above the interests of the client then this will result in allocative efficiency as they are acting in their own interests as agents rather than those of the principal. Another example of principal and agent is that between voters and elected politicians. The rationale for the existence of a representative democracy is that politicians, because of their specialization, are better informed than the general voting public and stand as agents of the voters. (Brown & Jackson, 1990. p. 204).
If politicians get the wrong idea about the preferences of the principles then there will be allocative inefficiency once again. In some cases, the suppliers of public services are not exploiting the customers/voters for profit but rather that in serving their own interests they may tend to over produce or to produce a quality of service in excess of what tax payers would be prepared to pay if they were better informed. (Brown & Jackson, 1990. p. 204) Due to budget constraints, public firms do not have the financial capabilities to provide powerful incentives unlike private firms.
Bonuses are not awarded for good performance nor can individuals be fired for misperfomance. Subsequently, public agencies are systematically less efficient as individuals are less complacent to be efficient or to provide the best services to their customers. Even if they do have any incentive, more often their aim directed at political goals rather than the objectives. Bureaucrats for instance, as explained by Stiglitz (2000) may not receive ample pay checks or considerable dividends from increased efficiency, but they often seem to enjoy the power and prestige associated with being in charge of a larger organization.
They attempt to maximize the size of their bureaucracy by reducing efficiency. The only thing that stops them from doing this is competition between bureaucracies. W. A Niskanen, implies that the increasing centralization of government bureaucracies has reduced competition, in doing so bureaucrats can pursue their interests at the expense of efficiency and the public interest. This is an example of the principle-agent problem. Here, the problem is, how do the citizens (the principles) get their employees, public servants (the agents), to act in their interests? (Stiglitz, 2000 p. 202) Revise.