When organizations fail

The G4S fiasco has led some to question - not necessarily consistently - whether the private sector is any more efficient than the public.

For me, the question makes little sense as an ideological one. Hierarchical organizations are prone to failures arising from adverse incentives, limited knowledge and bounded rationality (planning fallacy, anyone?).What matters is how organizations mitigate these dangers; whether they are in the public or private sector is not often the issue.

There is, however, a common claim - one I think I've made myself - I want to challenge. It's the idea that market forces mean that the failure of private sector organizations is less catastrophic than public sector ones.

Now, in many cases, this is true. When Woolworths collapsed, there was no generalized crisis; people simply bought their pic 'n' mix elsewhere. By contrast, when the "Border Force" screws up, people cannot use other means to get through immigration checks quickly.

What interests me, though, is that there are cases where private sector failure does have costs - and I don't just mean the fleeting political embarrassment that arises from G4S's failure.

The biggest and most obvious example of this was, of course, the banking crisis. It showed us that the collapse of a handful of organizations can have colossal macroeconomic effects.

I'd suggest three general ways in which private sector failures can have macroeconomic effects:

1, Common failures. If every organization is pursuing the same strategy, then any change which causes the strategy to lose money might kill off all organizations in an industry. Markets are like ecosystems (pdf).If there's insufficient biodiversity, environmental change will wipe out entire ecosystems.This is the story of banks.

2. Market blockages.Ashwin says: "When the incumbent fails, there must be a sufficient diversity of small and new entrants who are in a position to take advantage." But this is not assured.For it to be true we need (among other things) an entrepreneurial culture, a lack of barriers to entry and expansion and finance for entry and expansion. None of these are assured.

3. Being big enough to matter.As Xavier Gabaix has pointed out, some firms are sufficiently large that they matter for aggregate growth. The failure of one or two mega firms might then generate the sort of adverse productivity shock that RBC theorists fret about.

I reckon there are (at least) two implications here.

First, the standard macro-micro division of labour in economics can be dangerous, as it can blind us to the fact that micro failures can have macro effects.

Secondly, the question of whether private sector firms are well or badly managed cannot be left to the market, and nor can they be rectified by macroeconomic policies. The question of how private sector firms are managed is a legitimate political one. And this raises issues which the non-Marxist left has tended to ignore for too long.

Comments

[Chris Purnell]

Nothwithstanding your dislike of Polly Toynbee does she have a point that there has been generalised 'reputational'damage to out- sourcing as a positive solution? After all this follows the A4E fiasco where not only was there fraud but there was also a significantly worse outcome to the common activity. Out sourcing companies often pay minimum wages with few if any add-on benefits which is dis-incentivising.

[Zorblog]

I believe there is no intrinsic reason for a firm to be more efficient than the public sector. You may find plenty of examples of poorly managed firms (even very small ones) and well managed public institutions (even big ones).

But there are two dynamic reasons that make the private sector less likely to be poorly managed:
- Inefficient firms eventually go bust. It creates some kind of Darwinian selection.
- Firms have more straightforward decision-making mechanisms and hierarchical structures. They're able to react much more quickly (Darwinian mechanism again, you may say that firms is a species that adapt quicker than public institutions).

This does not mean that it is not possible to find advantages in favor of public institutions (guaranteed stability, absence of market-pressure, long-run oriented), but I suspect that overall the private sector is better armed.

In any case, there's probably worse than either firms or institutions: NGOs, associations and other not-for-profit structures (a thought derived from personal empirical experience)

[chris]

@ Chris - she's certainly right to bring it into question, and definitely right to deplore the hiding behind "commercial confidentiality" that prevents the question being explored. And she's right to say that it is just ideological gibber to say "public bad, private good".
My point is merely that the opposite of this (public good, private bad) is also dubious.
What matters is not so much the public-private divide but rather the detailed incentive structure of any organization.
What I'm driving at is that there is a case for worker ownership...

[Rosscoe_peco]

This seems a bit confusing, on the one hand you suggest that "the question of whether private sector firms are well or badly managed cannot be left to the market," which would seem to suggest that you require more regulation of firms in order to correct this.

Surely however this leads to both an increase in "common failures" as firms homogenise their approach to deal with the regualtory framework and an increase in "market blockage" as regualtion tends to be one of the largest barriers to entry to new entrants?

[Account Deleted]

@Zorblog, re:

"Inefficient firms eventually go bust."

Except that when they have achieved the status of incumbent supplier, marginal inefficiency becomes irrelevant. The cost of change is such that you have to be spectacularly bad to lose the contract, assuming it even gets re-tendered.

LOCOG have not called in another supplier in place of G4S, because no other supplier is able to mobilise in time. There is no market, hence the recourse to the public sector Army and police.

The problem is that efficiently functioning markets are rare in the real world, and that rarity correlates with the scale of the business and the contract. Inefficient small firms go bust. Inefficient large firms externalise their inefficiencies.

"Firms have more straightforward decision-making mechanisms and hierarchical structures. They're able to react much more quickly"

Or to put it another way, firms recognise fewer stakeholders whose interests they have to consider.

However, a more involved decision-making process does not necessarily mean a public body is slower to react. The armed forces may dither long and hard about aircraft carriers, but they seem able to react to a call for help pretty promptly.

[chris]

@ Rosscoe - I'm not arguing for more regulation, which has th danger you suggest, among others. I'm tentatively suggesting a case for workers control and less hierarchical decision-making.
The fact that this issue is seen as state vs markets, public vs private and regulation or no is v. depressing. There might be, ahem, a third way.

[Yet another Chris]

The problem is that only extremely large private sector companies have the resources to bid for government work. I work for a small company (<50) and we have given up on government contracts. The tenders run to hundreds of pages and the tender often has to be in in a matter of weeks. We simply don't have the people.

You could say we therefore don't have the resources to do the government contracts if we can't resource the bid. Wrong! We have completed work as a subcontractor to huge organisations, which can resource the tender but can't deliver the work (no expertise!!)

My daughter works for one such company. It has grown massive (GBP billions) on government contracts here, in the EU and around the world. Over 60% of its work is outsourcing for governments. If I'm honest her company adds very little value to anything but is merely an extension of the public sector. She is one of tens of thousands tasked to bring in government work. Much of this work is then subcontracted to companies like ours for 20% of the fee. Crumbs.

I think what I'm saying is the playing field is tilted in favour of the likes of G4S in the tendering process. As a result, these government subcontractors are getting very rich indeed on the taxpayers' dollar.

The solution is not to bring the work back in house to government employees. The solution is to stop doing the work altogether as much is unnecessary.

[Jim]

Yet another Chris is correct. The best solution is for the State to stop trying to do so much stuff. Then it won't run into the problems of there being only a few very large companies that are able to do its bidding. While its at it, it could stop creating barriers to entry in all sorts of industries by reducing regulation as well. Thus allowing more competition to virtual monopolies created by over regulation.

[alastair harris]

One of the lessons of history (and geography) is that catastrophe is a good thing. Surely the big problem with bailing out failing banks is that it leaves them free to fail again. Catastrophe is an important part of natural selection!

[Tim Almond]

"Secondly, the question of whether private sector firms are well or badly managed cannot be left to the market, and nor can they be rectified by macroeconomic policies."

I think the question here is about what sort of company they are. As you say, Woolies didn't really matter, but banking (and things like power and telecoms too) do.

But we had banking regulation and the purpose of it was to ensure that this sort of failure didn't occur, and it failed. The state, as the insurer of savings, has an obligation to ensure that those savings are not treated recklessly and failed to do so. The incentive here is that all 3 parties are signed up to the housing-as-investment philosophy and will not jeopardise that.

[Stella Phillips]

Organizations are facing big challenges right now, having the potential to change the economic situation in general but I think that the most flexible ones and also the ones being more protected will find their way to succeed.

[james higham]

Outsourcing is to become increasingly more the issue as the old chestnuts free trade and protectionism get another run. Nothing ever goes away - it just gets repackaged and relabelled.

[Alex]

Private sector organisations go bust. But this is a strawman argument. It's not, in fact, true that public sector organisations are typically left to continue normal jogging forever. Politicians and bureaucrats constantly demand "reform" and impose re-organisations, mergers, splits, contraction, expansion, targets, new roles or the loss of them, etc.

Part of this is driven by democracy and concern for performance. Part of it is merely driven by bureaucratic politics.

But it simply isn't true that there is no check on failure in the public sector.

The frequency of public sector reorganisation demonstrates that public sector management is, in fact, scrutinised. It may be scrutinised for the wrong reasons, or on the wrong metrics, and the policy proposals may be utter nonsense. But this is trivially normal in the private sector.