TCS Daily

The Highest-Cost Producer

By Arnold Kling - April 29, 2003 12:00 AM

As an economist, I am dismayed by the cavalier way in which politicians add to the roster of goods and services provided by the government. I cringe when I hear an official begin a sentence with the phrase "We need ____" where the blank might be filled in with "prescription drug coverage," "day care," "alternative sources of energy," or - most alarmingly--"to spend more money on education."

The political appeal of public provision of goods and services is that the recipients have the illusion of a free lunch. If you are paying hundreds of dollars a year for prescription drugs, and suddenly the government pays the cost, it seems as though you are getting something for nothing.

In fact, public provision of goods and services is anything but a free lunch. There is a textbook economic argument that shifting the method of funding goods and services from private-sector prices to public-sector taxes is very costly. There are at least three ways in which shifting from private provision to public provision lowers economic efficiency.

Inefficient Production

Compared with the private sector, government is not as motivated to select the most efficient production methods. Nor is the government as flexible and motivated to continuously improve its production processes.

In fact, inefficiency in government is so ingrained that people often take it for granted. For example, blogger Kevin Drum responded to a complaint by a taxpayer about the apparent failure of his satisfaction with government services to rise along with his tax bill by saying that compared with forty years ago, "much of the [increase in taxes] comes from the fact that we pay government employees more, just the same as we pay private sector employees more these days too thanks to rising GDP and increasing prosperity. School teachers, for example, are no longer expected to do their jobs for $15,000 per year."

Overlooked in Drum's analysis is the fact that the reason that private sector wages have risen is because productivity has gone up. The rise in private-sector productivity drives up private-sector wages, forcing government salaries to increase in order to keep pace.

In fact, if public-sector productivity were rising at the same rate as private-sector productivity, then a taxpayer could enjoy either a higher level of services, a lower level of taxes, or both. However, as the example of teachers illustrates, public-sector productivity lags far behind private-sector productivity. Because wages cannot be held down in line with low productivity gains, the cost of government services rises over time. Among economists, this phenomenon is known as Baumol's cost disease.


Demand is self-limiting when the consumer bears the cost of goods and services. The number of books that I purchase each month depends on my calculation of the benefit of owning the books relative to their cost. If the cost exceeds the benefit, then I stop buying.

On the other hand, if the government paid for my books, I would buy many more of them. Only storage considerations would limit my purchases.

Over-consumption tends to occur whenever government provides goods and services. For example, health care expenditures are on a sharply rising trend. There are many reasons for this, but one of them is the fact that many people feel that they are insulated from the cost of their lifestyle and health care decisions. When the government pays for health care, all of us pay more, and none of us has enough incentive to make choices that could lower the cost.

When demand is not self-limiting, it is up to the government to determine the level of its provision of goods and services. As blogger Kevin Brancato puts it, "how - on earth, not utopia - is it possible for the government to know if it is producing efficiently? Should it produce the good at all, charge more, or charge less?"

In the private sector, firms that are unable to provide goods at prices that cover their fixed and variable costs are forced to shut down. This prevents over-consumption. There is no comparable mechanism at work in the public sector.

Tax Distortions

Even if the government were to choose the most efficient production methods and limit output to prevent over-consumption, there would still be a reason to prefer private-sector pricing to taxpayer finance. That is because a dollar of tax revenue costs more than one dollar to collect.

An obvious cost of collecting taxes is compliance cost. Both the government and individuals have to put resources into the tax collection process.

A less-obvious cost of collecting taxes is the distortionary effect that they have on the economy. If you tax something, you get less of it. The income and payroll taxes punish work and thrift, which we otherwise would like to encourage. Even the real estate property tax is distortionary, because it reduces the incentive for owners to improve their properties. Taking into account distortions, the economic cost of $1.00 of tax revenue might be something like $1.25 or $1.50.

Education, Costs, and Benefits

All of these factors - inefficient production, over-consumption, and tax distortions - make government the highest-cost producer in the economy. Therefore, instead of looking for new opportunities to provide goods and services using tax revenues, politicians should be looking to hold government production to minimal levels.

For example, politicians talk about spending more on education as if this were a good thing. In fact, the more that the government substitutes public for private spending on education, the more resources it shifts to the high-cost producer.

There are public benefits to education, but those benefits are limited. By public benefits, I mean the benefits that do not accrue to the individual being educated. I have an incentive to obtain as much education as will benefit me. However, to the extent that my education also benefits you, then you might be willing to pay something to have me educated. Only this additional external benefit justifies taxpayer funding for education.

When the issue is formulated in these terms, it suggests a limited, narrow role for the government in supporting education. The government probably should provide support to poor people for obtaining education, because they otherwise may obtain sub-optimal amounts due to cash constraints. Beyond that, the case for government involvement in education becomes more difficult to make.

If we combine the limited extent to which education is a public good with the factors that make government the highest-cost producer, it becomes almost certain that the cost-benefit calculation for additional government spending on education is negative. In fact, on both equity and efficiency grounds, we would be much better off if we got the government out of the schooling business, except for need-based assistance to the poor and learning disabled.

Politically, it seems as though any attempt to shrink government is unthinkable. Democrats appear to be happy to tax and spend. Republicans appear to be happy to tax-cut and spend. But economists are obliged to remind everyone of the adverse consequences of shifting economic activity to the highest-cost producer.

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