ECON311: PUBLIC FINANCE POLICY AND PRACTICE, LECTURE NOTES 2013

PUBLIC EXPENDITURE APPRAISAL

Project Appraisal
Project appraisal is a general term which refers to attempts by applied welfare
economists to evaluate the efficiency of alternative projects or more widely the
efficiency of alternative policies. It is a means of assessing whether an investment
project is worthwhile or not.

Projects are a means towards achieving policy objectives. Many appraisal

techniques are used for project appraisal- Focus here will be cost-benefit analysis
(i.e. investment appraisal or option appraisal as applied to the public sector.)

Cost-Benefit Analysis (CBA)

CBA is a set of practical procedures for guiding public expenditure decisions.
Economic theory has been founded on the basis of a rational individual i.e. a person
who makes decisions on the basis of a comparison of benefits and costs. Social CBA
extends this to the area of government decision making by replacing private
benefits and costs with social benefits and costs. It is mostly frequently applied to
projects that involve public sector investments in capital projects such as the
building of hospitals, construction of highways, e.t.c.

Prest and Turvey (1968) said, “Maximize the present value of all benefits less that of
all costs subject to specified constraints”. They break this down into 4 interrelated
questions:

1. Which costs and which benefits are to be included?

2. How are the costs and benefits to be evaluated?
3. At what interest rate are the future benefits and costs to be discounted?
4. What are the relevant constraints?
The answers to these questions depend on whose welfare is to be maximized.
A. Private Firm Making An Investment Decision
1. Only private benefits and costs that can be measured in financial terms are
included. Benefits and costs are the financial receipts and outlays as measured
by the market prices. The difference between them is reflected in the firm’s
profits
2. The market rate of interest is used for discounting the annual profit stream
3. The main constraint is the funds constraint imposed on the expenditure
department

B. Social CBA
1. All benefits (private and social) are included whether they are direct, indirect,
tangible or intangible
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2. Benefits and costs are given by the standard principles of welfare economics.
Benefits are based on the consumers’ WTP for the project and costs are what
losers are WTA as compensation for giving up the resource
3. The social discount rate is used for discounting the annual net benefit stream.
The social discount rate includes preferences of future generations.
4. Constraints are allowed for separately, but are included in the objective function
e.g. Income distribution considerations are included by weighing the consumers’
WTP according to an individual’s WTP. A funds constraint is handled by using a
premium on the cost of capital i.e. social price of capital is calculated, which
would be different from its market price.

Discounting and Net Present Value

Project evaluation usually involves comparing costs and benefits that occur in
different time periods. The future unit has to be discounted to make it comparable
to a current unit.

The discount rate is the rate by which the PV of money received in the future may be
computed. E.g. sacrifice is $100 and return next year is $120. Is the project worth-
while?

We can’t subtract to obtain a net figure of $20. Why? Because $120 comes next year
and it will be worth less that it would if obtained today. If the interest rate i=10%,
then we discount: 120/ (1.10) = $109.09.

With future benefits discounted, both figure are on in PV terms and can be
compared. The net result is that the current year equivalent benefit of $109.09
minus current cost of $100 leads to a NPV of $9.09.

The decision rule to decide whether a project is worthwhile is that the NPV must be
positive.
T
Bt
In general: PV =  (1  r )
t 0
t
, …………. (1)

Where:-
PV- present value
B- dollar benefits received in any future year
t- period
(1+r)t- discount factor
r- discount rate

T
Bt  Ct
NPV=  ………………… (2)
t o (1  r ) n
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 Decision Rule

Only projects with a positive NPV should be considered. If only one project is to be
accepted among mutually exclusive projects, then the project with the highest NPV should
be considered.

Internal Rate of Return (IRR)

Instead of assuming the value of r and computing the NPV, we can find the IRR that
would make an evaluator indifferent about the project. The indifference point comes
where NPV=0, hence the evaluator will be indifferent between recommending for or
against the project.
T
Bt  Ct
NPV=  =0…………………….. (3)
t o (1  i) t

The internal rate of return will then be compared with the opportunity cost of K, r to
see whether the project has positive benefits. If i>r we accept the project. This implies
that the NPV of the project is greater than zero and the project should be recommended.

If funds are scarce, the government might array projects according to the value of i and
choose those project whose i is the greatest. (Project prioritization)

There is little difference between using IRR and NPV methods because if PV in equation
2 is greater than zero we will almost always find that i>r in equation 3.

Calculation

Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return
follows from the net present value as a function of the rate of return. A rate of return for which
this function is zero is an internal rate of return.

Given the (period, cash flow) pairs ( , ) where is a positive integer, the total number of
periods , and the net present value , the internal rate of return is given by in:

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The period is usually given in years, but the calculation may be made simpler if is calculated
using the period in which the majority of the problem is defined (e.g., using months if most of
the cash flows occur at monthly intervals) and converted to a yearly period thereafter.

Any fixed time can be used in place of the present (e.g., the end of one interval of an annuity);
the value obtained is zero if and only if the NPV is zero. In the case that the cash flows
are random variables, such as in the case of a life annuity, the expected values are put into the
above formula. Often, the value of cannot be found analytically. In this case, numerical
methods or graphical methods must be used.

Example
If an investment may be given by the sequence of cash flows

Year Cash flow

0 -1 000 000
1 300 000
2 500 000
2 500 000

Then the IRR is given by

In this case, the answer is 13.19%.

Problems with using internal rate of return

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive
projects, but only to decide whether a single project is worth investing in. In cases where one
project has a higher initial investment than a second mutually exclusive project, the first project
may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and
should thus be accepted over the second project (assuming no capital constraints).

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IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the
reinvestment can be the same project or a different project). Therefore, IRR overstates the annual
equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than
the calculated IRR. This presents a problem, especially for high IRR projects, since there is
frequently not another project available in the interim that can earn the same rate of return as the
first project.

Reasons for sticking to NPV

1. A mathematical ambiguity can arise in equation (3) because it is possible to get

multiple computed values of i and nobody knows what to do after that.
2. Another form of mathematical uncertainty can arise when comparing projects of
different time horizons. It will sometimes be the case that one project will have a
very high IRR over its lifetime but lasts only for a short while whereas another
pays less but lasts longer. If these projects are alternatives being ranked in terms
of their i, the only way to compare them is to use the NPV for both.
3. Sometimes the government decision maker will be comparing an investment
project with a Ci project that lasts for only one year and for which there is no
computed value of i. The present value rule give a clear answer because there
will be a PV of net benefits for the Ci project, just the net benefits in the first year
while the IRR does not have that.

THE BENEFIT-COST RATIO

Suppose that a project yields a stream of benebits B0, B1, B2, …, BT, and a stream of
costs C0, C1, C2,…, CT. Then the present value of all benefits, B, is

B1 B2 BT
B  B0    ... 
1  r  1  r 2
1  r T
And the present value of the costs, C, is

C1 C2 CT
C  C0    ... 
1  r  1  r 2
1  r T
The benefit-cost ratio is defined as B/C. Admissibility requires that a project‘s benefit-
cost ratio exceed one. The application of this rule always gives correct guidance. To see
why, note simply that B / C  1 implies that B  C  0, which is just the present value
criterion for admissibility.

As a basis for comparing admissible projects, however, the benefit-cost ratio is virtually
useless. Consider a state that is considering two methods for disposing of toxic wastes.
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Method 1 is a toxic waste dump with B=$250 million, C=$100 million, and therefore a
benefit-cost ratio of 2.5. Method 11 involves sending the wastes in a rocket to Saturn,
which has B=$200 million, C=$100 million, and therefore a benefit-cost ratio of 2. The
state’s leaders choose the dump because it has the higher value of B/C. Now suppose
that in the analysis of the dump, the analysts inadvertently neglected to take into
account seepage-induced crop damage of $40 million. If the $40 million is viewed as a
reduction in the dump’s benefits, its B/C becomes $210/$100 = 2.1, and the dump is
still preferred to the rocket. However, the $40 million can just as well be viewed as an
increase in costs, in which case B/C = $250/$140 =1.79. Now the rocket looks better
than the dump.

We have illustrated that there is an inherent ambiguity in computing benefit-cost ratios

because benefits can always be counted as “negative costs” and vice versa. Thus, by
judicious classification of benefits and costs, any admissible project’s benefit-cost ratio
can be made arbitrarily high. In contrast, with the NPV criterion such shenanigans have
no effect whatsoever because it is based on the difference between benefits and costs
rather than their ratio.

We conclude that the internal rate of return and the benefit-cost ratio can lead to
incorrect inferences. The NPV criterion is the most reliable guide.

INFLATION

The question is “how do we modify the procedure when the price level is expected to
increase in the future?” Consider a project that, in present prices, yields the same return
each year ($ R0 ) . Now, assume that inflation occurs at a rate of 7 percent per year, and
the dollar value of the return increases along with all prices. Therefore, the dollar value
of the return on year from now, $ R1 , is (1.07)*$ R0 . In general, this same return has a
dollar value in year T of $ RT  (1  0.07)T * R0 .

The dollar values are referred to as nominal amounts. Nominal amounts are valued
according to the level of prices in the year the return occurs. One can measure these
returns in terms of the prices that exist in a single year. These are called real amounts
because they do not reflect changes that are due merely to alterations in the price level.

When inflation is anticipated, both the stream of returns and the discount rate increase.
When expressed in nominal terms, the present value of the income stream is thus:

(1   ) R1 (1   ) 2 R2 (1   )T RT
PV  R0    ... 
(1   )(1  r ) (1   ) 2 (1  r ) 2 (1   )T (1  r )T

A glance at this expression indicates that it is equivalent to NPV equation because all the
terms involving (1   ) cancel out. The moral of the story is that we obtain the same

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 answer whether real or nominal magnitudes are used. It is crucial however that dollar
magnitudes and discount rates be measured consistently. If real values are used for the
Rs, the discount rate must also be measured in real terms- the market rate of interest
minus the expected inflation rate. Alternatively, if we discount by the market rate of
interest, returns should be measured in nominal terms.

DISCOUNT RATES FOR GOVERNMENT PROJECTS

Rates Based on Returns in the Private Sector

The public sector should compute costs, benefits, and discount rates differently from the
private sector. This section discusses problems in the selection of a public sector discount
rate and also the problems in the evaluation of costs and benefits.
For evaluating long-lived projects, such as dams, the choice of the discount rate is crucial: a
project that looks favourable using a 3% interest rate may look very unattractive at a 10%
rate. If markets worked perfectly, the market interest rate would reflect the Opp Cost of the
resources used and the relative evaluation of income at different dates. But there is
widespread belief that markets do not work well. Moreover, taxes may introduce large
distortions, with large differences between before-and-after-tax returns. Therefore it is not
clear which of the various market interest rates, if any, should be used. Should it be the rate
at which the government can borrow, or the rate at which the typical taxpayer can
borrow.?

If the individuals who benefit from the project are the same as those who pay the costs, we
can simply use their marginal rate of substitution, how they are willing to trade off the
reduction in current consumption for gains in future consumption. Their MRS is directly
related to the rate of interest at which they can borrow and lend. In this case we use the
market rate of interest for evaluating costs and benefits in different periods.

But often, the project may have further ramifications. A public project may displace a
private project. In this case we have to look at all the consequences, the net change in
consumption. If the public project displaces a private project of the same size, then the net
reduction in consumption today from the project is zero. If both the public and private
projects yield all of their returns in the same period, we should undertake the public
project if its output exceeds that of the private project. Or if its rate of return exceeds that
of the private project. This is called the opportunity cost view. The private sector project is
the opportunity cost of the public sector project. The producer’s rate of return is used in
the project evaluation.

Social Discount Rate

This is the rate at which society is willing to trade off present consumption for future
consumption. This rate may be lower than the market rate for several reasons:

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  Concern for future generations

It is the duty of the public sector decision maker to care about the welfare not only of the
current generation of citizens but of future generations as well. The private sector is only
concerned of its welfare, hence from a social point of view, the private sector devotes too
few resources saving- it applies too high a discount rate to future returns.

 Paternalism

Even from the point of view of their own narrow self-interest, people may not be farsighted
enough to weigh adequately benefits in the future; they therefore discount such benefits at
too high a rate. The government should use the discount rate that individuals would use if
they knew their own good. This is a paternalistic argument- government forces citizens to
consume less in the present, and in return, they have more in the future, at which time they
presumably thank the government for its foresight.

 Market Inefficiency

The idea is that firms tend to under-invest in projects that generate positive externalities.
Thus by applying a discount rate lower than the market rate, the government corrects this
externality. The only problem is in measuring the actual size of the eternality.

VALUING BUBLIC BENEFITS AND COSTS

From a private firm’s point of view, benefits are revenues received and costs are the firm’s
payments for inputs and both are measured by market prices. For the government this is
not the case because market prices may not reflect social benefits and costs.

Market Prices

Real world markets are not perfect and therefore they do not reflect the MSC of production
and the marginal value to consumers. The relevant question them becomes whether
market prices are likely to be superior to alternative measures of value.

Adjusted market prices

The prices of goods traded in imperfect markets generally do not reflect their marginal
social costs. The shadow price reflects the underlying social marginal cost of a good.
Shadow prices are estimated from market prices, depending on how the economy responds
to the government intervention.

Consider the case of a monopoly. If the government is to purchase an input from a

monopoly, should the government value the input at the monopoly’s market price (which
measures its valuation to consumers) or at its marginal production cost (which measures
the incremental value of the resources used in its production)? The answer depends on the
impact of the government’s purchase on the market. If production of the good (input) is
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expected to increase by the exact amount used by the government project, the social
opportunity cost is the value of the resources used in the extra production- the marginal
production cost. On the other hand, if no more of the good (input) will be produced, the
government’s use comes at the expense of consumers, who value the good (input) at its
demand price. If some combination of the two responses is expected, a weighted average of
price and marginal cost is appropriate.

If an input is subject to a sales tax the price received by the producer of the input is less
than the price paid by the purchaser. When the government purchases an input subject to
sales tax, should the producer’s or purchaser’s price be used in the cost calculations? The
basic principle is the same as that of the monopoly case. If production is expected to
expand the producer’s supply price is appropriate. If production is expected to stay
constant, the consumer’s price is appropriate. A combination of responses requires a
weighted average.

If a worker of a public sector project is hired away from a private job, then society’s
opportunity cost is the worker’s wage rate in the private sector, because it reflects the
value of the lost output that the worker had been producing.

Consumer Surplus

Public sector projects can be so large that they change market prices, and this affects the
way in which benefits should be calculated. For example, a gvt irrigation project could
lower the MC of agricultural production so much that the market price of food falls. But if
the market price changes, how should the additional amount of food be valued- at its
original price, at its price after the project, or at some price in between?

If the irrigation project induces an increase in the supply of food and hence a fall in the
price of food, consumer supply increases. (Illustrate using a demand and supply diagram).
Provided the planner can estimate the shape of the demand curve, the project’s benefit can
be measured. Changes in producer surplus can also be used to estimate the project’s
benefits.

INFERENCES FROM ECONOMIC BEHAVIOUR

Sometimes the good in question is not explicitly traded, so no market price exists. In those
cases, peoples’ willingness to pay for such commodities has to be estimated.

Value of Time

Applied in highway projects and how they save travel time. While it is true that “time is
money” to do cost-benefit-analysis we need to know how much money. A common way to
estimate the value of time is to take advantage of the theory of leisure-income choice.
People who have control over the amount they work do so up to the point where the
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subjective value of leisure is equal to the income they gain from one more hour of work-
the after-tax wage rate. Thus, the after tax wage can be used to value the time that is
saved.

Problems with the after tax wage are:

 Some people cannot choose their hours of work. Involuntary unemployment

represents an extreme case

 Not all uses of time away from the job are equivalent

By seeing how much extra money people are willing to pay for a faster mode of transport,
we can infer how much they are willing to pay to reduce their commuting time, and hence
how they value time. Of course other characteristics of people such as their incomes, affect
their choice of travel mode.

Value of Life

Lost earnings can be used to estimate the value of life. We calculate it as the present value
of the individual’s net earnings over a lifetime. If an individual dies as a consequence of a
given project, the cost to society is just the expected present value of the output that person
would have produced. Method used in the courts of law to determine compensation
relatives should receive.

Implication: society suffers no loss if the aged, infirm, or severely handicapped were
summarily executed. Method is sufficiently rejected by most economists.

Probability of death

Is a second approach. The idea is that most projects do not actually affect with certainty a
given individual’s prospects for living.

 Occupational choices

Some jobs involve a higher probability of death than others. Individuals in riskier jobs
are expected to have higher salaries to compensate for the higher probability of death,
all other things being equal. The difference between the salaries provides an estimate of
the value that people place on a decreased probability of death.

 Automobiles

An individual driving a light car is subject to a greater probability of death in an auto

accident than someone in a heavy car, other things being the same. People are willing to
accept the increased risk of death because of the money they save by purchasing lighter
cars.
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 Cancer research

You do not know that cancer research will save you life. All that can be determined is
that it may reduce the probability of your death. The reason this distinction is
important is that even if people view their lives as having infinite value, they continually
accept increases in the probability of death for finite amounts of money.

Many studies of the amounts that people are willing to pay for safety devices, such as
smoke alarms, that reduce the probability of death have been done with different
results. A rough guess on the basis of such research is that the value of life is between
$4 million and $10 milion (Viscusi, 2006).

VALUING INTANGIBLES

Eg, space shuttle programs that increase national prestige, a beautiful scenery in
national parks. Intangibles subvert the whole cost benefit analysis beause:

 Overvaluation means any project can be made admissible

Other methods of measuring them can be useful such as cost effective analysis can be
used- comparing the costs of the various alternatives that attain similar benefits to
determine which one is the cheapest.

Justification for Using CBA

a) The subject is more or less scientific than any policy area of economics. Its
strengths and weaknesses are those of welfare economics itself.
b) One needs to use CBA for some government decisions because it is too
administratively costly to hold an election every time a public decision needs to
be made.
c) Provided the objectives are the same for all projects and measured in a
consistent fashion, there is no necessary bias by CBA e.g. if environment factors
are considered to be important for one project decision, they must be considered
to be important for all project decisions. This guard against a policy maker
bringing in special factors that raise the net benefits only for those particular
projects that is personally preferred to him.

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EDUCATION

Introduction

In this section we deal with education from a public finance perspective because:

 Education is a good case study for the application of the tools of public finance
 Government spends enormous amounts of money on it. Comparing to all other
sectors, education take the biggest share of the national cake.

Table1: Proportion of expenditure to total budget (%)

Health Education Highr Education

2010 7.7 14.1 5.1
2011 9.3 17.1 5.8
2012 8.6 17.7 7.4
2013 8.6 17.6 7.1
2014 8.5 17.1 7.2

Health and Education Expenditures

6000000000
5000000000
4000000000
US$mil

3000000000
2000000000
1000000000
0
2009 2010 2011 2012 2013 2014
Yaer

Health Education Highr Education Total budget

It is important to note that education is rival in consumption, at least to some extent. As the
number of students in a classroom increases past some point, each student receives less
individualized attention from the teacher, the classroom becomes more congested and
there are other strains on educational resources. Education is also excludable because one
can easily prevent a student from obtaining the services provided by a school. For instance,
university of Zimbabwe students are required to display their student ID cards during

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lectures. In short, education is essentially a private good, improving students’ welfare by
enhancing their ability to earn a living and more generally, to deal with life.

Although education is a private good it provides some benefits to other people in society. It
serves as a powerful source of socialization and it helps to make an informed cohesive
citizenry, which serves an especially important function within a democracy. Dee (2004)
found that additional schooling leads to greater voter participation, more frequent
newspaper readership, and more tolerance for free speech.

Higher education vs. Primary and Secondary Education

The magnitude of the external benefits of education likely varies by education level. For
example, if the socialization benefits of education exhibit diminishing marginal returns,
then elementary and secondary schooling generate higher external benefits than higher
education. This suggests that government should intervene less in higher education than in
primary and secondary education. Indeed, most governments subsidise higher education
less than primary and secondary education.

Some argue that college education should be subsidized more because it increases
productivity. That college increases productivity may be true, but as long as the earnings of
college graduates reflect their higher productivity, there is no externality. For the
externality argument to be convincing, one must show that there are productivity gains due
to higher education that do not increase the student’s future earnings. Even if higher
education provides positive externalities, this would not provide an efficiency justification
for a government programme which subsidises all eligible students at the same rate. The
idea is that not all college training produces the same level of externality. Art, history,
accounting, premedical courses do not necessarily produce the same externalities.
Efficiency therefore requires that they be subsidized differentially.

Proponents of subsidies however argue that if they were removed, fewer people would
attend college. Removing subsidies would increase private costs for individuals. If subsidies
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were granted to young people who wanted to open auto repair shops and these were cut,
then the number of auto repair shops would also decline.

Some argue that this argument is invalid because it ignores imperfections in the private
sector market for loans. It is very difficult to provide collateral for loans for human capital-
investments that people make in themselves to increase their productivity- so these
lending markets might not materialize. For that reason, some students for whom the
benefits of higher education exceed the costs might nevertheless not go to college due to
lack of funds, which is an inefficient outcome. One solution for this problem is for the
government to make loans available to any student at the market rate of interest. However,
the prospect of heavy debt after graduation would no doubt discourage some students
from borrowing. But that may be the wisest form of restraint. Someone finally has to pay
the bill, and it is hard to see why that should be the taxpayers rather than the direct
beneficiary of the schooling (Passell, 1985).

Arguments for public education and for subsidizing higher education can also be made on
equity grounds. The notion of commodity egalitarianism suggests that fairness requires
that some goods be available to everyone. If education is a normal good, then we would
expect a free market for education to lead to different levels of education for different
income classes, with some lower-income people perhaps winding up with little or no
education. The view of commodity egalitarianism is prevalent especially with respect to
elementary and secondary education (universal primary education for all).

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 SOME EMPIRICAL EVIDENCE

Does Spending on Education Improve Student Test Scores?

The Coleman Report [Coleman et al., 1996]

 They attempt to evaluate the effect of expenditures on student outcomes

 Results show that family background and peer effects- not the amount of public funding of
schooling- explain student performance
 However, this was an observational study. The problem with it is that it is very difficult to assess
causal effects
 E.g if more educational resources were devoted to remedial classes, then there could be
negative correlation between expenditures and student outcomes even if expenditures helped
students.
 A better approach would be to run an experiment that randomly assigns students into high-and
low spending schools, and then measure the differences in test outcomes. While a few
randomized studies have been done, they are difficult to conduct and are therefore rare.
 Several recent studies instead use quasi-experiments that take advantage of changes in state
laws that have increased funding to some school districts relative to others.
 Guryan (2003) found that increases in per-pupil spending led to significant increases in math,
reading, science, and social studies scores for 4th and 8th grade students. (USA)
 Hanushek (2002) surveyed a large body of previous studies and found that in most cases the
data do not support a relationship between student expenditure and student performance. One
contentious question regarding this claim is how to account for expenditures on a relatively
small group of disabled students- should the expenditure numbers be corrected so that only
money spent on “regular” students is taken into account? Without such a correction, a cross-
sectional analysis of the relationship between expenditures and student outcomes could be
misleading if schools spend more money on low-performing remedial or disabled students.

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Does reducing class-size improve student test scores?

 Reducing class size involves both costs and benefits

 The costs arise because the goal can be achieved only by hiring more teachers and by providing
more classrooms.
 The costs are relatively straightforward to measure
 Measuring benefits is rather more difficult because it is complicated to estimate the casual
relationship between class size and student outcomes.
 Observational studies of the impact of class size are biased if students in smaller classes are
different from students in larger classes, and if these differences contribute to differences in test
scores.
 For example, if wealthier families locate in schools with smaller classes and children from their
families tend to get better test grades in any case, then we would overestimate the independent
effect of smaller classes.
 Tennessee Student/Teacher Achievement Ratio experiment (known as Project STAR) Randomly
assigned kindergarten students to small classes (13 to 17 students per teacher)and larger classes
(22 to 25 students per teacher). Krueger (1999) found that students in the smaller classes tested
higher than students in the larger classes. In a follow up study, Krueger and Whitmore (2001)
concluded that the students who were assigned to the smaller classes were more likely to take a
college entrance exam and that this effect was greater for African-American students.
 Despite the fact that the empirical literature has produced mixed results, policy-makers are by
and large convinced of the virtues of class size reductions. The results of Project STAR reinforced
policymakers’ beliefs that class size reductions are a good thing. However, one must be careful
about assuming that the results of an experiment in one setting will hold in another setting.

NEW DIRECTIONS FOR PUBLIC EDUCATION

Charter Schools

Some economists are convinced schools would improve if they were forced to compete
with one another to attract students. This is part of the motivation for charter schools,
which are public schools that operate under special state government charters. Within
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limits established by their charters, these schools can experiment with a variety of
approaches to education and have some independence in making spending and hiring
decisions.

Vouchers

Under a voucher, financial support is given to students rather than directly to schools. Each
student could be given a tuition voucher, for example, that could be redeemed at whatever
qualified private school suited the candidate’s family best. Proponents of school vouchers
believe that the effects of competition from private schools would be as salutary in the
education market as they are in other markets. Terrible public schools that do not reform
would lose enrollees and be forced to close. Parents’ and students’ perceptions of teacher
quality, which are more or less ignored by the public school system, would become the
basis for punishing bad teachers and poorly run public schools. In addition, the availability
of tuition monies would prompt entrepreneurs to establish new private schools in areas
where the existing schools are poor.

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THE HEALTH CARE MARKET

Rationale for a role of government in the health care sector

Rising costs are a major concern of Zimbabwe’s health care system. Over 7% of the national
budget is devoted to health care alone. When we include other income from donors and
well-wishers, the proportion of resources devoted to health is huge in Zimbabwe. Health is
one of the sectors with the haggiest external support by donors.

In the presence of huge expenditures in health, the health care market is full of
imperfections. The following four market imperfections exist in the health care market: (1)
imperfect information, (2) limited competition, (3) the large roles of nonprofit institutions
and (4) problems with the insurance industry in the health care sector.

1. Imperfect information

When consumers go to a doctor, they are buying the doctor’s knowledge and/or
information. As a patient, the consumer must rely on the doctor’s judgment as to what
medicine is required or whether an operation or other procedure is advisable. Because
they lack medical expertise, patients cannot effectively assess and evaluate their doctor’s
advice. They may not even be able to tell whether a doctor is qualified. This explains why
governments license doctors and regulate the drugs doctors can administer to their
patients.

These information problems exceed those faced by consumers in other areas. In the case of
repeat purchases, like groceries, consumers either are able to judge the quality of the
products themselves or come to rely on a grocery store (say, for the freshness of its
vegetables). But individuals typically don’t have a repeat purchase of medical procedures
such as kidney replacements, heart bypass surgery, or even ulcer treatments. In the case of
products like cars, there are independent rating agencies that test the product and describe
its strengths and weaknesses. But there are simply too many doctors and hospitals and too
many procedures for that to be feasible in the health care sector: a hospital may be too
good at one procedure and weak at another. Success may depend on subjective factors, like
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a doctor’s personal manner, which may work well with some individuals and not with
others. Even report cards on say the fraction of heart bypass patients that survived on year
may not be fully informative, because hospitals in one region may have an intake of sicker
patients than hospitals in another.

Insurance companies also encounter information problems relating to doctors and

patients. Like patients, they must largely rely on doctors to determine what procedures are
necessary and useful. Imperfect information about patients creates information problems
in the market for insurance.

2. Limited Competition

Imperfect information reduces the effective degree of competition. A firm selling a standard
commodity, like a Nokia phone, knows that it can attract customers away from other stores
by lowering its price. Customers can easily ascertain where they are getting the best value
for their money. By contrast, potential patients who see a doctor with lower prices than her
competitors may infer that she is not in great demand and is therefore trying to attract
more customers; but the apparent lack of demand for her services may suggest to them
that she is not a good doctor.

By the same token, the heterogeneity of medical services makes price and quality
comparisons difficult and thus inhibits the effective dissemination of information. My
neighbor may be pleased with the medical treatment that he obtained from his doctor, but
if his medical problems are different from mine, his satisfaction is no assurance that I will
be pleased if I go to the same doctor. And if I hear that one doctor charges more than
another doctor, to evaluate whether one is better I have to know precisely what services
were offered.

Completion also limited in the health sector because:

 Doctors used not to be allowed to advertise. This tend to bid up the prices of medical
services e.g spectacles

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  In many communities there are few doctors from which to choose

 There is also limited competition among hospitals. Most small communities have at
most only a few hospitals. In the event of an emergency, an individual seldom is in a
position to choose from among many. And even when there is time to make a choice,
the choice is made not by the individual but by his doctor.

3. Absence of profit motive

Not for profit hospitals do not view their objective as simply minimizing the cost of
delivering medical care, or maximizing profits. The consequence is that these hospitals will
be reimbursed for their expenses by government and by private insurance companies. In
most cases, these hospitals will be paid whatever they charged. The absence of a profit
motive discourages efficiency and innovativeness in medical services delivery.

THE ROLE OF INSURANCE

Understanding the theory of insurance will help us both to understand health care issues
and to analyse government programs that protect people against a variety of adverse
events. These programs are collectively known as social insurance.

Health insurance works in the sense that buyers pay money, called an insurance premium
to providers of insurance, who in turn commit to disburse some amount to the insured
person should an adverse health event such as illness occur. Other things being the same,
the greater the insurance premium, the more compensation the buyer receives in case an
illness occurs.

Individuals are risk avers; that is why they buy insurance. They would rather pay a certain
amount every year to the health insurance company than go one year with little
expenditure because they are lucky and have no illness or accident, and another year with
high expenditures when they are less lucky.

Dissatisfactions with the insurance provided by the market arise because:

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  Some people buy too much insurance, and insurance induces excessive expenditure
on health care

 Many people cannot obtain insurance (there is too little coverage) or can obtain it
only at an expensive cost; and

 Transactions costs are excessive

Insurance and Excessive Expenditures on Health Care

When individuals buy insurance, they no longer pay the full costs of health care. The
problem that with insurance, individuals spend too much on health care is called the moral
hazard problem. The insurance industry has long worried that insurance would increase
the likelihood of whatever was insured against; it thought of this as a moral problem- with
excessive fire insurance, an owner of a property might even be induced to burn down his
building. Economists view the issue simply as one of incentives. With insurance, incentives
to maintain health and control health expenditure are attenuated. There is a trade-off. The
more insured, the less risk the individual buys, but the weaker are incentives, and thus the
greater the overall costs. Optimal insurance balances off these trade-offs.

There is a concern that government policies led to excessive insurance, and because
insurance is excessive, expenditures on health care are excessive. The tax system
subsidizes insurance. Employer- provided insurance premiums are essentially a tax-free
form of compensation.

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