Scarcity and choice
As a prelude to my intended discussion of the 2013 Annual National Budget after it is presented to the National Assembly later this month, in last week’s column I had started an appraisal of the management of government investment spending in Guyana. I began with a discussion of the limited funds (or scarcity of public resources) available to all governments and the need therefore, for them to make choices when seeking to satisfy what are effectively the unlimited wants (desires) that exist everywhere.
I sought to establish that, from the perspective of government spending (investment), the economic (opportunity) cost of this spending is measured by what is lost from the next best possible alternative use of those funds, which is foregone in order to make the choice in favour of present spending. Indeed, this principle applies to all those economic choices which are made (whether by governments, private businesses or individuals) in the context of scarce means and unlimited wants (desires).
This principle forms the basis for routinely applying benefit-cost analysis (or as it is also termed, cost-benefit analysis) to all government spending. For private businesses, economists would assume that, as a rule, their investment choices are guided by the intention to maximize profits.
If this is the case, then we may generalize and say that private investment projects are driven by the desire to obtain the highest possible revenue and incur the least possible cost; or, in other words, maximize profit.
This result is then compared to the profits that could be obtained from alternate investments. The most profitable of these is then chosen.
Private versus public
investment
As we shall see later, the objective of profit maximization in private businesses is supposed to be the driving economic force behind a country’s competitiveness, innovation and ability to provide customer satisfaction to its citizens. If private firms fail to compete efficiently, they usually lose market share, sales, customers, and worse, could eventually go out of business. The penalty therefore, for not following the rule of the best alternate use of resources is customarily very harsh in the private economy.
For government investments, however, inefficiency, waste, and poor customer service can persist for a long, long time. Why is this the case? This is due to the consideration that public spending is financed by taxpayers’ money (or public borrowing).
This puts governments in a position where their spending can be driven by political and other reasons, thereby permitting them to adopt a posture where commercial losses are a second-order priority as long as the project makes sufficient political gains.
In last week’s column I indicated that the circumstances described here constitute a first principle of investment management.
Another associated first principle is that, private businesses can value their flows of revenues (benefits) and costs based on prices obtained in private markets. Government investments, however, cannot simply employ private market prices to arrive at the value of benefits and costs of a project. For this purpose cost-benefit or benefit-cost analysis when applied to government spending is termed social cost – benefit, or social benefit-cost analysis.
Private and social cost benefit
I shall amplify on the differences between private and social benefit-cost analysis at a later stage. For now readers should bear in mind two basic considerations, which often present difficulty for laypersons to grasp.
One of these is that, when dealing with private businesses, it is quite plausible to regularly apply the rule of maximizing profit, whenever choosing from among alternate use of resources.
Thus, for example, a firm introducing a new technique to the production process, or a new sales strategy, would evaluate the costs and revenues earned from this, and then compare it to the use of the same amount of funds in other areas of activity, in order to pursue the most profitable. However, governments are never presented with such a straightforward preference function or objective to guide them, when spending taxpayers’ money.
In practice governments may have multiple preferences for their investment projects. Some examples of these are to maximize employment; to secure foreign investment; to promote national savings and investment; to prioritize infrastructural investment; to transfer technology; and to enhance local skills and capacities.
These are only a sample of preferences employed around the world by governments. Clearly these varied preferences have to be prioritized and combined in such a way as to produce a clear unambiguous preference function, which economists can consistently apply to their evaluation of all government projects.
The emphasis on all government projects is deliberate, for without this the management of government investment spending is bound to be wasteful and inefficient.
A second consideration which follows from the above discussion, is that there are at least two major reasons why the market cannot provide accurate valuations for determining social costs and benefits. I gave the example last week of labour valuation to illustrate this.
There I pointed out that to a private firm, the cost of each worker it employs is given by what it pays in the labour market.
With long-run structural unemployment as in Guyana, some economists might put the social labour cost for a government project at zero (as has been done before by the IMF, World Bank, and IDB). Taxation provides another good example.
Taxation is a cost to private business and reduction of revenue earned. But from the standpoint of Guyana as a whole, taxes are essentially transfer payments between the public and private sectors.
Second, several of the goals governments have expressed a preference for (as in the examples given above) do not even have private markets from which to guide their valuation.
Next week I shall continue the discussion from this observation.
