Economists approach the question of whether to privatize services by starting from the premise that well-functioning, competitive markets without "market failures" will provide services at least as efficiently as the government. Hence, their approach is to identify those circumstances under which the markets do not do well, suggesting that in these cases privatization is not appropriate (Blank 1999). Four market failures may exist in the provision of social services, limiting their suitability for privatization or at least suggesting that certain safeguards might be necessary.(2)
- Externalities. Externalities in social service provision will occur when persons other than the intended recipients are affected by the social services. An example of a positive externality is when job training leads to a reduction in crime. An example of a negative externality is when the opening of a drug rehabilitation center reduces property values in its neighborhood. A private organization, not taking into account these externalities, would not provide an optimal level of the service.
- Incomplete Information about the Services. For competitive markets to work effectively, buyers must have reasonably complete information about the services they are choosing. But in many social services, this level of information might be difficult to achieve. In some cases, the services are simply too complex for untrained consumers to fully understand, as in the case of some health care services or training programs.
- Agency Problems. An agency problem may occur when the person purchasing the service is not the customer or recipient of the service. This might occur if the beneficiaries are not thought to be able to make good decisions about their own interests. Examples of such beneficiaries include young children or severely developmentally disabled adults. It has also been argued that welfare recipients might not have the capacity to act in their own best interests.
- Insufficient Competition. Finally and critically, competitive markets for any type of service cannot function effectively if there is not adequate competition. If the cost of entry into the market is high, new firms or organizations will have difficulty entering it, and competition will be constrained. Other major barriers to entry or local markets that are simply too small will also inhibit competition (GAO 1997b, 1997c).