This seemingly straightforward task, however, is fraught with

This seemingly straightforward task, however, is fraught with
difficulties
for many of the services provided by government. What, for
instance, is
the appropriate measure of service provided by local schools or
a city
police department? Although amounts of money spent on those
functions—expenditures—are the most readily available and
commonly
used measure of the quantity of service, that measure often is
not informa-
tive. Additional expenditures that do not translate into more
educated
students or a safer environment may not represent more
"service."
Throughout this section of the book, and particularly in Chapter
7, the
problems of appropriately measuring service and the limitations
of using
expenditures as that measure are emphasized.
Finally, governments implement their decisions about providing
goods
and services through budgets and budget policy. Even before the
tax-limit
movement, state-local governments had experimented with a
variety of
budget structures and restrictions. Understanding those
constraints and
their effects on fiscal decisions may help clarify why some
states respond
to economic and fiscal changes differently from others and may

suggest
the advantages and disadvantages of similar budget policies for
the
federal government.
CHAPTER 7
COSTS AND SUPPLY OF STATE AND
LOCAL GOODS AND SERVICES
. . . Rising unit costs have been a major (probably the
single most important) source of recent increases
in local public budgets. 1
—DAVID BRADFORD, R.A. MALT, AND WALLACE OATES
"LIKE MANY STATES, NEW JERSEY CONTRACTS WITH
AN OUTSIDE VENDOR TO HANDLE. THE BACK-
OFFICE SIDE OF ITS WELFARE AND FOOD STAMP
PROGRAMS. PART OF THAT OPERATION, RUN BY AN
ARIZONA - BASED COMPANY CALLED EFUNDS, IS A
SMALL CALL CENTER THAT HANDLES TELEPHONE
INQUIRIES FROM BENEFICIARIES. STATE OFFICIALS
CAUGHT FLACK LAST YEAR WHEN THE VENDOR
MOVED THE OUTFIT FROM GREEN BAY, WISCONSIN TO
BOMBAY, WHERE SALARIES FOR ANSWER-
ING CALLS ARE IN THE RANGE OF $2 TO $4 AN HOUR. IN
THE WELFARE-TO-WORK AGE, CRITICS
SAY, IT'S UNFA1R—AND HUGELY IRONIC—TO SHIP
ENTRY-LEVEL JOBS SUCH AS THESE OVERSEAS.

SO NEW JERSEY NEGOTIATED WITH EFUNDS TO BRING
THE JOBS BACK. IN MAY, A NEW
CALL CENTER OPENED IN ECONOMICALLY DEPRESSED
CAMDEN, WITH SEVERAL NEW EMPLOYEES
HIRED FROM THE WELFARE ROLLS. . . . NEW JERSEY
AGREED TO PAY EFUNDS AN ADDITIONAL
$888,000 A YEAR AS COMPENSATION FOR THE HIGHER
COST OF DOING BUSINESS IN CAMDEN.
... MORE AND MORE U.S. CORPORATIONS ARE MOVING
CALL CENTERS, DATA PROCESSING,
AND OTHER BACK-OFFICE WORK TO NATIONS SUCH AS
INDIA, ISRAEL, AND THE PHILIPPINES..
WITH THEIR BUDGETS IN SHAMBLES, STATE AND
LOCAL GOVERNMENTS MAY BE
INCLINED TO TURN TO CHEAP OVERSEAS LABOR. 2 "
HEADLINES
I sThe Rising Cost of Local Public Services: Some Evidence
and Reflections." islational Tax purruil, 22 (June 1969): 201.
2 "Answering the Call Center's Call." Governing Magazine.
July, 2003.
141

PART III ■ PROVISION OF STATE AND LOCAL GOODS
AND SERVICES
In economics, analyzing supply is essentially analyzing
production cost. The cost
of producing alternative amounts of output, combined with the
structure of the
market, determines how producers behave. Similarly, the costs
of producing
services provided by state-local governments and the factors
that alter those costs
are crucial for understanding and comparing the fiscal behavior
of subnational
governments.
Before discussing production technology and cost, one needs to
define and mea-
sure the good or service produced, which is not straightforward
for many services,
including those provided by state-local governments. For
example, education is
the dominant subnational government service in the United
States; the question is
whether education output should be measured by dollars spent
per pupil, by the
number of graduating students, by student test scores, or by
some other measure.
The action required to increase each of these alternative
measures of education may
be different so that the cost of producing "more" of each may
vary and even depend
on different factors. The first task in this chapter is to consider
alternative ways to
characterize the output of state and local government services
so that "cost" is
defined properly and to investigate the factors that affect cost

(and thus supply).
MEASUREMENT AND PRODUCTION OF GOVERNMENT
SERVICES
Production Functions 3
To produce services, state-local governments purchase inputs
such as labor ser-
vices, capital goods, materials, and supplies and combine them
to provide public
facilities, or what can be called directly produced output, such
as police patrols or
classrooms with teachers and books. The ways inputs can be
combined to produce
this type of output are together referred to as technology and
can be represented
mathematically by a production function. For instance, the
directly produced
education output is a function of the number of teachers and
administrators, the
number of buildings and classrooms, and the number of books,
desks, and other
equipment provided. Mathematically
Q = q(L, K, X)
where
Q = directly produced output
L = labor input
K = capital input
X = the set of other inputs such as materials and supplies

The q() function represents production technology. Any given
amount of di-
rectly produced output usually can be produced by different
combinations of
3The discussion in this section follows that in David Bradford,
It A. Malt, and Wallace Oates (1969).
ER SEVEN ■
COSTS AND SUPPLY OF STATE AND LOCAL GOODS AND
SERVICES
„ as
—that is, there is usually more than one way to combine inputs
to produce
sicrvice. In other words, the production function q( ) does not
specify a unique
°is') tit combination for each output but rather the possible
input combinations to
:hprimsdpuerccodeosetti
aoctchfiolnevte
technology
producing
oouloantpgyyutam.
amount of directly produced output depends both on
and the prices of the required inputs. In defining
production
cost, economists usually assume that for each possible level of
output,

producers select the combination of inputs that will produce the
chosen output at
lowest cost. 4
For instance, if K1, and X1 are the amounts of inputs that will
produce output Qi at lowest cost, then the
Cost of Qi = tvLi + rKi + pX1
where
w = the price of labor
r = the price of capital
p = the set of prices for the other inputs.
Of course, this cost of the directly produced output is also the
expenditure of the
government on this service.
These public facilities or directly produced outputs provided by
state-local gov-
ernments may not reflect the services consumers desire,
however. One can argue
that citizens are more concerned about results than production;
for instance, the
education output of interest is knowledge and skills acquired
rather than merely
the number of classroom hours per year. The service result,
which is what
individuals consume or use, depends both on the directly
produced output by the
government and on the characteristics of the community and the
population.
For example, an equal number of classroom hours, teachers, and

books will not
necessarily produce an equal amount of learning in districts
with different num-
bers and types of students. It is useful, therefore, to distinguish
consumer output,
or the final result for consumers, from the directly produced
output or facilities.
Mathematically,
G = g(Q, X, N, E)
where
G = consumer output
X = private goods purchased directly by individuals
N = population to be served
E = environment, a set of community and population
characteristics
g( ) = transformation function from output to results
40f course, governments might not always select the minimum
cost input mix. For instance, it has been argued that
due to patronage consideration or public-employee unionism,
state-local governments may choose to use more
labor than is cost minimizing.
► 43
0009 SEVEN •

SERVICES
Sa n plc Output Measures for Selected State—Local Services
as
Table 7.r
AND SERVICES
The "cost" of producing more directly produced output Q is
different from the
"cost" of producing more consumer output G. The latter depends
on private con-
sumption by residents and on community characteristics E and
N, which are often
outside the direct control of the state or local government.
Private consumption
may raise G if individuals purchase goods or services that
contribute to the public
service, such as private education or locks or smoke detectors;
private consump-
tion might reduce G if consumption imposes greater burdens on
the public service,
such as with consumption of alcohol and drunken driving.
Changes in population
or the environment may require a larger Q, just to keep G
constant. For instance, to
reduce class size from 25 to 20 students requires 25 percent
more teachers and
classrooms (assuming teacher workload and school operating
hours are to remain
the same), but such a change may not provide a 25-percent
increase in the desired
result of "learning" per student; indeed, it may not increase

"learning" at all!
This discussion suggests that the output of state-local
governments can be mea-
sured in at least three different, broad ways. Output can be
measured by the
amount of money spent by a government on a service, which is
referred to as
expenditure; however, expenditure is really a measure of the
inputs used by the
government in the production process. Alternatively,
government service may be
measured by the amount of directly produced output provided
by the govern-
ment. Finally, government service may be measured by results,
by the level of con-
sumption enjoyed by citizens.
Examples of how these three different measurement concepts
can be applied to
specific state-local government services are shown in Table 7.1.
Fire protection ser-
vices, for instance, may be measured by the amount of money
spent on firefight-
ers, stations, trucks, and other inputs; by the number of
hydrants and stations per
square mile; or by some mix of the number of fires (prevention)
and damage per
fire (suppression). Similarly, police protection services may be
measured by expen-
ditures on officers, vehicles, jails, and other inputs; by the
number of police patrols
per square mile; or by the number of arrests made and crimes
solved. Similar mea-
sures can be devised for every service function or responsibility
of state-local gov-

ernments. But which measure is best? Or perhaps more
appropriately, how do the
measures differ in the information they provide?
Expenditures Compared to Produced Output
Directly produced output on a service can fall even though
expenditures are con-
stant or even increasing. Similarly, two different subnational
jurisdictions with
equal per-capita expenditures on a particular function can
provide different pro-
duced outputs for that service.
Expenditures equal costs, and costs depend both on the amount
of inputs used
and the prices of those inputs. If the prices of inputs rise, then it
will cost govern-
ments more to provide the same produced output. Of course,
governments may
select a different production technology if relative input prices
change—using rel-
atively less of those inputs whose prices increase the most—but
even then, total
cost for every amount of directly produced output will increase,
although perhaps
Patrol officers, supervisory
officers, stations, radios,
vehicles, jails, weapons
Teachers, books,
buildings, desks,
classrooms,
computers, and
other equipment

by less than if the government did not alter production methods.
It follows that if
input prices differ for different subnational jurisdictions, equal
expenditures do
not necessarily translate into equal produced output. Simply
put, if teachers of the
same quality cost more in one state than in another (and all
other inputs cost the
same), equal per-pupil expenditures in the two states translate
into larger class
sizes in the higher-cost state or less of some other input (books,
for example).
These implications are very important because expenditures are
the most com-
monly used measure of subnational government output, at least
for comparisons
over time and among different jurisdictions. Over time,
however, increases in
Input prices require increased expenditures unless directly
produced output falls
or unless new ways (technologies), which require fewer inputs,
for producing
those services can be found. M with consumer expenditures, one
can attempt to
144
Service
Fire Protection
Police Protection
Education
Inputs

Firefighters, inspectors,
stations, trucks, equipment,
water supply
Direct Outputs Consumption
Stations per sq. mile, Fire Prevention and
firefighters per Suppression: No. of
station, trucks per fires per household
station, hydrants per or employer,
sq. mile damage ($) per fire,
civilian fire deaths
per fire, fire
insurance rates
Stations per sq. mile, Crime Prevention
no. of patrols (or and Punishment:
patrol officers) per Crimes per capita
sq. mile, no. of (perhaps by type),
intersections with civilian deaths
traffic control, no. and/or injuries
of jail cells per capita from crime, amount
($) of stolen
merchandise,
arrests per crime,
crimes solved per
reported crime
Teachers per student, Knowledge and
books per student, Skills: Average
classroom hours per &/or variance
year, class size, of test scores,
no. of subjects percent graduating

taught on time," percent
attending college,
percent employed
after x years,
added earnings
Table 7.2
Special District
AND SERVICES CHAPTER SEVEN ■ COSTS AND SUPPLY
OF STATE AND LOCAL GOODS AND SERVICES
146 1 47
allow for changing input prices over time by deflating
government-expenditure
data with a price index, usually the GNP implicit price deflator,
which is separately
available for federal and state-local government expenditures.
No such general
correction is available for comparisons among different
jurisdictions, although
evidence exists of substantial variation of some input prices
among different
state-local governments. Particularly, land prices and labor
prices appear to vary
widely at different locations, and both inputs are purchased in
substantial amounts
by state-local governments.
Produced Output Compared to Consumed Output

The consumed output or result for a particular service could
decline or worsen
even though a government provides constant or even increasing
direct output. In
fact, even if two governments provide equal directly produced
output, citizens in
those jurisdictions may receive different amounts of consumed
output-that is, get
different results or benefits as consumers.
The consumer output, which results from a given amount of
directly produced
output, depends on private consumption and on the
environmental characteristics
of the community and population. Between two cities with
identical fire depart-
ments, one might expect more fires and more serious fires in the
city with fewer
smoke detectors or with older buildings or with more wooden
(as opposed to
metal or brick) buildings. Equal fire protection in both cities
may require more
directly produced output in such a city-perhaps fire stations
closer together,
more pumper trucks per capita, or a more aggressive fire-
inspection program.
Similarly, as environmental conditions change over time,
directly produced out-
puts must change if consumer results are to remain the same. Of
course, the envi-
ronment can change in a positive way over time as well,
requiring less produced
output to maintain consumer results. For instance, if building
materials and tech-
nology mean that newer buildings are at lesser risk from fire or

if individuals
more commonly keep fire extinguishers at hand, then the
amount of directly pro-
duced fire-protection output consistent with constant fire
protection could
decline.
There are four reasons government expenditures may not be
very good mea-
sures of the ultimate benefits received by consumers from
government production.
Differences among jurisdictions or changes over time in (1)
production technology,
(2) input prices, (3) community environmental characteristics,
and (4) private con-
sumption patterns all can intervene in that relationship. For
instance, rising expen-
ditures may be sufficient to maintain constant produced output,
given rising input
prices, whereas a deteriorating environment may require
increased produced out-
put to maintain results. Thus, rising expenditures may not be
inconsistent with
falling consumed output or declining service quality. The
opposite also may be
true. In some cases, decreasing expenditures can be consistent
with rising service
results or quality if input prices decrease, the production
environment improves,
and/or individuals substitute private consumption for public
service. Therefore, at
the very least, these four factors must be considered and
evaluated when using
government expenditures for comparison purposes.
Among government policy makers, the idea of focusing on

results rather than
spending is referred to as benchmarking. States and localities
evaluate their pro-
grams by a series of benchmarks or performance measures
comparing that juris-
diction to others. For instance, Governing reports that
"Mississippi plans to shift
away from old-style line-item budgeting that merely measures
inputs-what the
e
is spending on specific programs-to one that measures
outcomes-what,
isast that, o
the
in Mississippi contend, "If government begins to measure the
effects
actually, is the effect of all that government spending" (Walters,
1994, 33). The hope
e focus on outcomes will allow governments to better allocate
resources.
O
of its activity rather than merely what it spends on those
activities, those effects-
'results'-will begin to drive the budget process" (Walters, 1994,
34).
employment and Labor Coots
When expenditures are used as the measure of the amount of
government service

supplied, output is actually being measured by the government's
costs, and the major
component of state and local government costs is for labor. As
shown in Table 7.2,
about 34 percent of state-local government direct noncapital
expenditures in 2002
went to cover compensation of employees. Labor costs
represented 45 percent of
those expenditures by local governments, on average, but 63
percent of direct
expenditures in school districts. In comparison, labor costs were
only about 13 per-
cent of federal government noncapital direct expenditures in
2002. The reason for
the much greater importance of labor costs to states and
localities compared to the
federal government is the difference in the nature of services
provided by those gov-
ernments. State and local governments mostly provide goods
and services to indi-
viduals and businesses, which requires a substantial amount of
labor to produce.
The federal government mostly transfers money either to people
(such as with
Wages and Salaries as a Percent ob Noncapital Direct
Expenditure,
by Type off Government, Selected years
Level of Government
Year Federal State-Local State Total Local County Municipal
Township School District
1967 27.5
1977 203

1972 28.7
1987
1
1992 12.0
1982 7
13.8
16.1 9
2002 10.2
'2001
SOURCE: U.S. Department of Commerce, Compendium of
Government Finances, table entitled Governmental Expenditure
by Character and
Object, various years. U.S. Department of Commerce,
Governmental Finances, various years.
1997 10.4
54.5
51.2
45.2
42.0
40.7
37.7
36.5
33.6
42.7
39.7
31.5

30.1
29.3
25.1
23.8
20.4
60.5
57.9
54.5
50 50.3
48.6
47.6
46.6
44.8
48.0
44.9
47.5
45.0
42.8
40.8
395
40.2a
56.2
523
47.5
42.9
41.6
38.4
38.7
na
52.4
54.7
54.6

47.9
45.6
44.7
45.6
na
74.1
73.4
68.8
66.7
65.7
65.1
64.5
63.1 a
41.7
41.6
38.4
33.0
29.1
31.4
30.3
27.7 a
CHAPTER
SEVEN ■ COSTS AND SUPPLY OF STATE AND LOCAL
GOODS AND SERVICES
1 49
Table 7.3
[ state and Local Government employment and Earningo
Full-time Equivalent

-•
Year
State-Local
Employment
(thousands)
Percent of
Total
Employments
State-Local
Full-time
Equivalent
Employmentb
I, State-Local Employment
as Percentage of
All State-Local
Employment
State-Local
Ave. Annual
Earnings
per FIE`
1965 7,696 12.7% 6,937 90% S 5,616
1970 9,823 13.9 8,528 87 7,818
1975 11,937 15.5 10,111 85 10,900
1980 13,375 14.8 11,047 83 15,142
1982 13,098 14.6 10,829 83 17,826

1986 13,794 13.9 11,852 85 21,631
1990 15,219 13.9 13,080 86 27,732
1992 15,117 13.9 13,182 87 29,529
1997 16,733 13.6 14,214 85 33,273
2002 18,349 14.1 15,602 85 40,235
'State-local employment as a °A, of total nonagricultural payroll
employment.
bFull-time equivalent employment adjusts for the number of
part-time employees.
'Average annual compensation per full-time equivalent
employee.
SOURCES: Bureau of Labor Statistics Web site; U.S.
Department of Commerce, Public Employment, various years.
the average state-local salary. During that same period (1990-
2002), per capita per-
sonal income in the United States increased about 82 percent
and consumer prices
(measured by the CPI) increased about 38 percent. It is very
difficult to compare
salaries or wage costs of state-local governments to those of the
federal govern-
ment or private business because of substantial differences in
the work activities
provided in those different components of the economy. One
study by Bradley
Braden and Stephanie Hyland (1993) showed that comparing
aggregate data, the
cost per employee for wages, salaries, and benefits appears to
be much higher for
state-local governments than for private industry. Much of this
difference disap-

pears, however, when accounting for the differences in the mix
of work activities.
Braden and Hyland note that "Compensation costs were similar
for industry activ-
ities common to government and the private sector" (1993, 15).
PRODUCTIVITY AND COSTS
Input price increases lead to increased costs of providing state -
local government
services unless the input price increases are matched by
increases in productivity.
Further, because of the substantial importance of labor costs for
state-local
governments, changes in wages and worker productivity should
be particularly
important. But the market for state and local government
workers is not isolated
from the rest of the economy. Changes in the demand for and
supply of
labor throughout the economy can have important implications
for the costs of
social security and Medicare) or to state-local governments
(through grants). The
federal government produces few services directly, so its labor
cost share is lower.
If comparison is limited to expenditures for current operations,
labor costs are
obviously an even larger share. In 2002, employee
compensation was 41 percent of
current operation expenditures for state-local governments
together, about 27 per-
cent for states, and more than 50 percent for all local
goverrunents. 5

For the 35 years represented in Table 7.2, the labor-cost share
of direct expendi-
tures for all levels of government in the United States decreased
substantially.
From 1967-2002, labor costs decreased from 42.7 to 20.4
percent of direct expendi-
tures for states and from 60.5 percent to 44.8 percent for local
governments. Simi-
larly, the labor-cost share of direct expenditures for the federal
government fell
from 27.5 percent to 10.2 percent. This decline in the labor -cost
share partly reflects
some external factors (interest-cost shares are greater now), but
also reflects
changes in what state-local governments do and how they do it.
As governments
make relatively more transfer payments, for instance, the labor -
cost share of
spending falls because the government is spending the money
on direct payments
rather than on labor. Similarly, if government substitutes capital
for labor in pro-
ducing some services-automated trucks for sanitation workers,
for example-the
labor-cost share also will fall.
In 2002, state and local governments employed more than 14
percent-that is,
one in every seven-of all payroll employees in the United
States, as shown in
Table 7.3. The share of total employees working for state-local
governments
declined from 1975 to 1997, but has risen a bit since. Similarly,
although the num-
ber of state-local government employees was about constant

from 1980 through
1986, it grew by more than 20 percent from 1990 to 2002. Given
the importance of
labor costs to state and local governments, it is not surprising
that this pattern mir-
rors the course of state-local government expenditures relative
to income noted in
Chapter 1-the state-local government sector grew compared to
the rest of the
economy until the mid-1970s, changed little during the 1980s,
but has grown at a
faster rate than the economy since.
A substantial number of state and local government employees
work part time
rather than full time. Although states and localities had more
than 18.3 million
employees in 2002, only about 13.8 million or 75 percent were
full-time employees.
Full-time equivalent employment adjusts for part-time workers
by computing the
number of full-time workers needed to replace part-time
workers (so two employ-
ees each working half time are equivalent to one full-time
employee). Since the
mid-1980s, there has been little change in the ratio of full -time
equivalent to total
employment, suggesting that the use of part-time employees by
states and locali-
ties has not changed much.
In 2002, state-local governments paid an average salary of
about $40,200 to full-
time employees. Compared to 1990, this represents about a 45
percent increase in

5 Direct expenditures are total expenditures excluding
intergovernmental transfers. Expenditures for current
operations are direct expenditures excluding expenditures for
capital, assistance and subsidies, interest, and
insurance benefits. Expenditures for current operations
represent money spent for current goods and services.
PART Ill • PROVISION OF STATE AND LOCAL GOODS
AND SERVICES
1 4 8
Supply
Supply g
- - r
MRP 8 =
Demand for labor
SuPPIYA
MRPP
Demand
for labor
MRPE,
Col LA Labor in A
(a) Sector with productivity gain

WageA
W
A
WA
Wages
PART Ill ■ PROVISION OF STATE AND LOCAL GOODS
AND SERVICES CHAPTER SEVEN al COSTS AND SUPPLY
150
151
Productivity gains
cause wage
increases
providing state-local government services. This relationship
among worker
productivity, wages, and production costs between the state-
local sector and the
rest of the economy is the basis for one well-known theory
about state-local
government costs. This perspective is valuable in understanding
the growth of
state-local government spending.

The Baumol Hypothesia
In a now well-known 1967 article, William Baumol argued that
productivity
increases in some sectors of the economy would force wage
increases throughout
the economy, increasing the production costs in those sectors
where productivity
improvements do not occur. Professor Baumol further argued
that the nature of
some services, including many of those provided by state-local
governments,
effectively precludes productivity gains because the essence of
the service is the
labor itself. Higher wages simply cannot be offset by
substituting other inputs for
labor. For those services, unit production costs would certainly
increase, and the
choice for consumers is either to reduce consumption of the
service substantially
or to spend ever-increasing amounts to continue consuming
current levels.
The first part of Baumol's argument is represented in Figure 7.1.
The economy is
divided, somewhat artificially, into two sectors, one where
productivity gains
occur relatively easily and regularly (Figure 7.1a) and one
where productivity
gains are difficult to achieve (Figure 7.1b). For this second
sector, Baumol has in
mind labor-intensive services with little opportunity for
capital/labor substitution.
In his words (1967, 416),
"There are a number of services in which the labor is an end in

itself, in which qual-
ity is judged directly in terms of amount of labor. Teaching is a
clear-cut example. . . .
Here, despite the invention of teaching machines and the use of
closed-circuit
Lq Lg Labor in B
(b) Sector without productivity gain
television and a variety of other innovations, there still seem to
be fairly firm limits
to class size. . . . An even more extreme example is one I have
offered in another
context: live performance. A half-hour horn quintet calls for the
expenditure of
2 1/2 man hours in its performance, and any attempt to increase
productivity here
is likely to be viewed with concern by critics and audience
alike. 6
Which services and to what degree this characterization applies
is debatable.
The point here is that productivity gains for some state-local
services are more dif-
ficult to achieve than in some other industries. Accordingly, the
demand for labor
in both sectors is shown in Figure 7.1, with demand less elastic
in that sector where
substitution for labor is more difficult. Note that the demand for
labor is labeled
the marginal revenue product of labor (MRP), which is the extra
revenue a firm

receives from hiring one additional unit of labor. The marginal
revenue product is
marginal revenue times the marginal product of labor and thus
depends both on
labor productivity and the value of the product produced. From
microeconomic
principles, a profit-maximizing firm will employ additional
labor as long as the
marginal revenue product is greater than the marginal cost of
another worker,
which is the wage in a competitive labor market. The demand
for labor, then, rep-
resents the benefit to a firm from more labor, which must be
compared to the cost
of hiring another unit of labor.
An increase in labor productivity in sector A is represented by
an increase
(a shift up) in the demand curve for labor; marginal revenue
product is greater for
every amount of labor because workers now produce more. The
increase in labor
productivity brings an increase in wage, at least in a
competitive labor market. Pre-
sumably, the same occurs in a controlled labor market as unions
recognize the
increased productivity of their members and bargain
accordingly. The increase in
wage in labor market A means that workers in sector A are now
earning a relatively
higher wage compared to those in market B than before the
productivity improve-
ment. The relatively higher wages in A attract workers from
market B, causing a
reduction (a leftward shift) in the supply curve of workers to
market B and an

increase in the wage of workers in B. In essence, employers in
market B must
match the wage increase in market A to retain employees.
These wage increases have very different effects in these two
sectors. For sector
A, workers are earning and producing more so that cost per unit
of output need not
increase. For sector B, the higher wages have been forced by
changes in the other
market and are not matched by productivity gains; remember
that the premise of
sector B is that substantial productivity gains are not possible.
Therefore, the cost
of producing a unit of sector B output rises. If B represents the
position of
state-local governments (and other industries as well),
productivity gains in the
industrial sector of the economy cause cost increases in the
production of
state-local government goods and services.
'Perhaps Baumol did not foresee the advent of computer-based
music synthesizers, so that one programmer-
performer could produce the horn quintet. But one might
suspect that Baumol, and others, would see this
option as substantially changing quality. In essence, the
performance by the synthesizer is a different good (or
bad) completely when compared to the quintet.
Figure 7.1
AND SERVICES

152
CH APTER SEVEN ■ COSTS AND SUPPLY OF STATE AND
153
BI Bo
Quantity of B
B 1 Bo Quantity of B
(a) Inelastic demand
(b) Elastic demand
10220111
How increases in
costs of govern-
ment services
affect spending
on services
Price
(S)
P1

Price
($)
P 1
Po
Po
The effect of these cost increases on consumption of sector B's
output is repre-
sented by Figure 7.2. If the demand for output B is price
inelastic (Figure 7.2a), then
the increased cost results in a higher price but only a small
decrease in quantity. As
a result, total expenditures on service B rise. If demand for
output B is price elas-
tic (Figure 7.2b), then the cost increase causes only a small
increase in price but a
large decrease in consumption. As discussed in Chapter 4, the
evidence suggests
that the demand for the services provided by state-local
governments is very price
inelastic. Therefore, the implication of the Baumol hypothesis is

that productivity
gains in some sectors of the economy will force increasing
amounts to be spent on
state-local government services. This is consistent with state-
local government
expenditures representing a larger and larger share of income.
This problem will
remain as long as private-sector productivity gains continue and
public-sector pro-
ductivity gains are difficult to achieve.
This story, although simplified, seems applicable to many actual
circumstances.
As wages in manufacturing and the business-service sector rise,
fewer students
may be attracted to teaching, a phenomenon that can be
particularly evident for sci-
ence, math, or business teachers who may find an attractive
private market for their
general knowledge and skills. As improved technology becomes
a more important
factor in manufacturing and demand for engineers and computer
specialists rises,
it becomes more and more difficult and expensive for
universities to staff engineer-
ing schools. Of course, as noted by Baumol, the process applies
to many other ser-
vices such as the arts, restaurant me als, fine hand-crafted
furniture, and clothes.
Evidence: Government Productivity
It is difficult to measure directly productivity change in the
production of govern-
ment services precisely because it is difficult to measure the
output being pro-
duced. One study (Hulten, 1984) attempted to measure

productivity change in
state and local governments indirectly, however, by using the
difference between
directly produced output and consumed output. Households can
be thought of as
nroducing all final services by purchasing and combining
different directly pro-
rduced outputs, some provided by the private sector and some
by government. (For
instance, a household combines a privately produced
recreational vehicle with a
publicly provided park to produce a service called camping.) In
that case, the share
of public-to-private expenditures depends on the relative prices
of the products
and relative change in productivity and environmental factors
for the sectors. The
combined change in productivity and environmental factors for
the state-local sec-
tor can be inferred from observed data on the share of state-
local expenditures in
GNP and relatiire prices.
Using quarterly data for the 1959-1979 period, Charles Hulten
estimated the
annual rate of change of the combined productivity
/environmental factor to be
-0.50 percent, although the estimate was not significantly
different from zero.
Hulten reported that one "cannot reject the hypothesis of zero
productivity growth
for the state-local sector" (p. 261). Perhaps more accurately, if
there had been
productivity growth over this period, it was not sufficient to

offset a deteriorating
production environment. After noting that private-sector
productivity had
increased at an average 1.45-percent annual rate over this
period and that the
state-local share in GNP had risen substantially in this time,
Hulten concluded
that "the results of this paper are thus consistent with the
Baumol hypothesis on
unbalanced growth. . . ." (p. 263).
Evidence: Government Coats
Other studies have directly examined the costs of producing
state-local government
services and changes in those costs over time. In one such
study, the changes in the
prices of inputs and workloads from 1962-1972 for different
state-local government
services were computed and compared to changes in
expenditures for those ser-
vices over the period (Sunley 1976, reporting work by Robert
Reischauer). For
instance, local school input prices include teacher salaries, book
prices, and trans-
portation costs, whereas workload is the number of school -age
children. If expen-
ditures increased more than required by increases in input prices
and workloads,
the remainder is assumed to represent increases in amount or
quality of service.
The result of this study was that 52 percent of the increase in
total state-local
expenditures over this 10-year period was due to increases in
input prices and that
13 percent resulted from increased workloads. Thus, only about

35 percent of the
increase in state-local government spending in that decade
represented increased
quality or new service. There were, however, substantial
variations for different
types of service. Workload and price increases were particularly
important for
highways and parking, health and hospitals, and police and fire
protection. The
increase in input prices and workloads alone were sufficient to
increase total state-
local government expenditures from 11.4 percent of GNP in
1962 to 12.0 percent of
GNP by 1972. As shown in Table 7.3, this was a period when
state-local govern-
ment wages were increasing rapidly in an attempt to catch up
with private-sector
wages. As suggested previously, state-local sector costs are
influenced by changes
In the rest of the economy, and increases in state-local
expenditures do not neces-
sarily represent increases in output or service.
AND SERVICES
Percentage Change in Private-Sector Productivity and State-
Local Coto
TECHNOLOGY AND THE PRODUCTION OF PUBLIC
SAFETY
The essence of the Baumol hypothesis is that
it is difficult for service providers, including

state and local governments, to increase labor
productivity by using more capital-intensive
production technologies. However, in the
case of one traditional state-local service-
police protection and public safety-some
new technologies involving electronic
inputs-computers and information databas-
es, computer analyses of physical and biolog-
ical evidence, electronic devices for gathering
data, new weaponry-are being used by
various jurisdictions. These methods hold the
promise of producing public safety service
more efficiently and perhaps lowering costs,
but sometimes also raise difficult questions
about the role of government and whether
capital technologies change the meaning of
"public safety."
The use of cameras always has been com-
mon in private security work, including for
surveillance in banks, retail stores, apartment
building entrances, and in recent years at
automated teller machines. However, only
since 1985, the prices of state-local goods have increased
relative to those in the
private sector. In the 1985-1995 period, productivity growth
slowed to about
1 .5 percent annually, so the increases in labor earnings (70.2
percent) resulted in
increases in business unit-labor costs (25.7 percent). The fact
that unit-labor costs
in business did not increase even more may be due to increased
international labor
market competition. Earnings in the state-local sector increased

even more, so
prices of state-local goods increased more than those of private
consumer goods.
Beginning around 1995, productivity began to increase
substantially at a rate of
about 4 percent annually. Earnings continued to grow at about 7
percent annually,
but growth of unit-labor costs slowed to only about 1 percent
yearly as a result of
the productivity change. Although earnings in the state-local
sector did not
increase as much as in private business, they did grow faster
than private unit-
labor costs, and thus prices of state-local goods and services
rose about twice as
much as those of private consumer goods.
The fact that the relative costs of state-local goods continued to
increase due to a
relative increase in labor costs suggests that states and localities
have not discovered
ways of increasing labor productivity as much as in the private
sector. If govern-
ments cannot find these new technologies or production
arrangements, then the
fundamental assumption of the Baumol hypothesis continues to
apply. The result-
ing fiscal pressure for state-local governments was somewhat
hidden in the 1990s,
as the state-local tax structure continued to generate substantial
revenue as a result
of fast national economic growth. As that ended with the
national recession in 2001,
however, the resulting enormous fiscal pressure for states and
localities returned.
Two possibilities for government productivity change are

considered next: the use
of new technology to produce old services in Application 7.1
and the possibility of
substituting private production of government goods in the
following section.
Application 7.t
CHAPTER SEVEN ■ COSTS AND SUPPLY OF STATE AND
1 5 5
Implicit Price Deflator
Business
Earnings
State-local
Period Productivity
Unit Labor Cost
All State-local Consumption
Expenditure
1963-1973 27.4 46.7 73.7 81.9 38.6 71.3
1973-1982 4.6 109.1 102.4 89.1 96.1 109.2
1982-1985 6.1 6.5 13.3 17.5 12.6 14.5
1985-1995 16.5 25.7 70.2 86.4 27.8 35.6
1995-2004 32.6 11.7 57.2 46.1 13.0 27.8

SOURCES: Economic Report of the President, 1986 and 1993.
US. Department of Commerce, Survey of Current Business, July
issues, various years.
U.S. Department of Commerce, Bureau of Economic Analysis
Web site.
From the latter half of the 1970s through the first half of the
1980s, state-local
government expenditures did not rise relative to income,
however, suggesting that
some aspect of the story changed. Possible explanations are that
large producti-
vity gains have, in fact, been made in producing state-local
services or that the
demand for state-local services has become more price elastic.
The evidence
reported in Table 7.4, however, suggests that the inverse of the
Baumol hypothesis
was operating from the mid-1970s through the early 1980s-low
productivity
growth in private industry helped to hold down relative state-
local sector costs.
From 1973-1982, average annual earnings for full-time
employees in all indus-
tries rose by 102.4 percent, although business productivity,
measured as output per
unit of labor, rose by only 4.6 percent; consequently, unit labor
costs for business
rose by 109.1 percent. Over these years, increases in private-
sector wages were not
matched by productivity gains, so business labor costs rose
substantially, presum-
ably inducing business to demand less labor. Fewer private-
sector jobs created

some slack in the labor market, allowing state-local
governments to hold down
wages. Over these years, average annual full-time employee
earnings in state-local
government rose 89.1 percent, losing ground to private-sector
earnings. As mea-
sured by the GNP implicit price deflator, the prices of consumer
goods rose 96.1 per-
cent over these years while the price of state-local services rose
109.2 percent.
Although the price of state-local services rose slightly
compared to private con-
sumer goods, the difference was much smaller than in the other
two periods, when
private productivity gains were large. Therefore, state-local
government expendi-
tures decreased from about 11.2 percent of GDP to 10.6 percent
over these years.
The short 1982-1985 period is similar to the 1963-1973 period
when substantial
business productivity gains allowed earnings to rise with only
modest increases in
labor costs. The increase in state-local earnings during the
1982-1985 period is
much greater than the increase in business unit-labor costs, and
therefore the price
of state-local services is again increasing much faster than the
average price of
private consumer goods. Thus, as expected, the share of GDP
represented by
state-local expenditures increased slightly between 1982 and
1985.

Pepper ... and Salt
THE WALL STREET JOURNAL
0
7;
01.
"This is Officer Holloway. You are exceeding
the speed limit by 6 mph. A ticket is being
faxed to you."
Source: Reprinted from The Wall Street Journal—Permission,
Cartoon Features Syndicate.
August 27, 1993, p. A9.
pTER
PART PROVISION OF STATE AND LOCAL GOODS AND
SERVICES SEVEN • COSTS AND SUPPLY OF STATE AND
157
Application 7.1 — Technology and the Production of Public
Safety
'Application 7.1 — Technology and the Production of Public
Safety
acceptance often cause serious problems. In
the case of photo-radar, the camera identifies
the vehicle and not the driver, so the penalty
must be against the registered owner of the

car, who may not be the user. If the owner is
required to "prove" that he or she was not dri-
ving the vehicle at the time of the infraction
to avoid penalty, is the presumption of inno-
cence lost? Technological advances to fight
crime also often result in technological
advances to defeat the new enforcement
technology, as illustrated by the ad in Fig-
ure 7.4 for"Photo B locker" to prevent enforce-
ment cameras from reading license plates.
is Also, The Wall Street Journal reported that
manufacturers of radar detectors were work-
ing on new devices to detect photo-radar
(which is shot across rather than along the
road). Finally, thinking about other uses of
cameras, one can reasonably ask whether
people would feel "better off" or even "safer"
if they were being watched all the time.

In short, technology can be used to
improve efficiency, increase worker pro-
ductivity, and reduce costs in providing
public safety service; however, these tech-
nologies also change the nature of the "pub-
lic safety" service. This issue raises the possi-
bility of an interesting economic choice to
be faced by voters. Voters can accept the
new technological methods of producing
public safety and enjoy lower costs (and
taxes) but suffer a loss of privacy, or they
can retain privacy by continuing to pay
higher and higher costs for producing
public safety with less invasive technology.
In essence, individuals might be asked
to put a value on the privacy that might be
lost in adopting these new technologies.
recently state and local police agencies have

adopted and expanded the use of cameras
and other electronic equipment. For instance,
The Wall Street Journal (Patterson, 1988)
reported about photo-radar, a high-speed
camera attached through a computer to a
radar gun, commonly used in Europe and
being used in California and some other
states. If the radar detects a speeding vehicle,
a photograph is taken, the vehicle is identified
by the license number, and the registered
owner is sent a summons (requiring the
owner to pay the fine or appear in court). In
Australia, similar types of camera-detectors
are used to monitor vehicle stops at traffic
lights or signs. Owners of vehicles that run the
lights (or signs) are mailed the evidence along
with the equivalent of a traffic ticket. The pos-
sibilities for this type of enforcement seem

limited only by imagination, as reflected by
the accompanying Pepper . . . and Salt cartoon
(Figure 7.3).
*sim il a rly, computerized information data-
bases hold out the possibility of providing
information about individuals, things, or
events broadly to public safety officials
quickly and at low cost. Information about
individuals is perhaps most controversial. In
theory, it would be possible for public safety
agencies to access extremely detailed per-
sonal information about any person that
could be used in solving specific crimes or
even predicting potential criminal activity. Of
course, to be useful this information must be
available widely, which increases the danger
that it might be misused.
Finally, electronic monitoring now
being used to track or restrict persons who

are under investigation or who have been
arrested for or convicted of crimes. An "elec-
tronic tether" that emits an electronic signal
can be attached to an individual's body
(usually the ankle), allowing officials to
monitor the signal and know the location of
the individual. Such a system might be used
to prevent flight by someone waiting for
trial, as a means of partial confinement
(nonwork hours, for instance) for someone
who has been convicted, or to monitor the
behavior of someone on parole. One can
envision other types of electronic aids in
enforcing laws, promoting safe behavior,
and apprehending violators.
Obviously, some electronic public safety
activities might violate various provisions of
the U.S. and state constitutions, especially

concerning such topics as privacy, unrea-
sonable search and seizure, and the pre-
sumption of innocence. Even when these
measures are constitutional, however, imple-
menting the measures and gaining public
158
AND SERVICES pTEIR SEVEN ■ COSTS AND SUPPLY OF
STATE
AND LOCAL GOODS AND SERVICES
have you been
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cop yet?
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4
Degrees ob Public and Private Involvement in Provision of
Service&

Choice of
Quality/Quantity
Public
Public
Public
Private
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Financing
Public
Public
Private
Private
Production
Public
Private
Private
Private
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PhantomPlate products Ago, tr ram ft have been featured on
EM61.,
What Is Privatization?
One idea that has been proposed to increase the productivity of
government and
thus reduce costs is to transfer production of government
services to private firms,
which is called privatization. The term privatization has been
applied, however, to

several different ways of increasing the activity of the private
sector in providing
public services, as outlined in Table 7.5. The traditional public
service situation is
case 1: public-sector choice, financing, and production of a
service. The other cases
represent various degrees of privatization: private-sector choice,
financing, and
production of a service, perhaps involving deregulation of
private firms providing
services; public-sector choice with private-sector financing and
production; and
public-sector choice and financing with only private-sector
production of the ser-
vice selected. The first simply means that all responsibility for
a service is trans-
ferred from the public sector to individual consumers who select
the amount of ser-
vice they desire and purchase that service from private
suppliers. As an example,
solid-waste collection is provided and produced by some local
governments but left
to private choice and private collection firms in other
communities. This essentially
can be characterized as "let the private sector do it alone."
The second and third versions of privatization refer, however, to
joint activity of
the public and private sectors in providing services. In cas e 2,
the notion is that
consumers collectively select and pay for the amount and type
of service desired
through government, which then contracts with private firms to
produce the ser-
vice. The only difference in case 3 is that consumers pay

privately for the service
selected publicly. As discussed in Chapter 6, some local
governments often con-
tract with other governments to produce services in order to
take advantage of
economies of scale. Contracting with private firms to produce
goods and services
also may reduce costs. For the example of solid-waste
collection, the idea is that the
community selects a level of collection service and the
government contracts with
a private firm to do the collection and disposal. The service
might be financed by
government taxes and fees or by prices charged by the private
producer. The gov-
ernment provides for the service, although a private firm
produces the service.
Privatization has been an issue in recent years as some states
and localities have
experimented with or at least considered privatization for
services usually both
provided and produced by government in the past. These
concepts of privatization
are focused on in this chapter.
Private production of publicly selected and financed goods and
services can be
applied to intermediate goods used by government in producing
services (such
as cars and trucks, paper, machines, and materials), to services
consumed by
government in carrying out its responsibilities (such as
maintenance and repair,
construction, data processing, and management and financial
services), and for
the final services consumed directly by taxpayers (such as

education, police and
fire protection, and transportation). In the first instance,
privatization is nearly
universal. Few, if any, governments or government agencies
produce their own
furniture, forms, buses, or computers—all are purchased by the
government
from private producers. Concerning the other possibilities, in a
review of priva-
tization experience, Robert Poole and Philip Fixler (1987, 617)
noted that "most
privatization at state and local levels of government has been
applied to either
routine housekeeping services in which government itself is the
customer (main-
tenance of public buildings, vehicles, and infrastructure) or
public services with
well-defined tangible outputs (garbage collection or recreation,
for example)."
Increasingly, however, government is considering or
experimenting with pri-
vate production of traditional public goods, including publi c
safety services and
education.
2000-2005 photoblocker.com . All rights reserved.
PRIVATE PROVISION OF PUBLIC SERVICES
AND SERVICES

CHAPTER SEVEN ■ COSTS AND SUPPLY OF STATE AND
161
How Might Privatization Reduce Coats?
In its simplest form, the argument is that government producers
have no in-
centive to hold down production costs, whereas private
producers who contract
with the government to provide service do. Suppose, for
example, that a private
firm contracts with a local government to pick up six bags of
garbage per
house per week in the community for a fee of $100 per house
per year. Obvi-
ously, the lower the cost incurred by the firm in satisfying the
contract, the
greater profit it makes. Competition among potential private
suppliers for this
contract (for a limited period, after which government can
change contractors)
is expected to bring government the lowest possible cost for the
specified level of
service. As summarized by Janet Rothenberg Pack (1987, 527),
". . . competi-
tive bidding by profit-maximizing firms for a well-specified
output guarantees
that the product will be produced at the lowest cost. The
absence of compe-

tition and profit incentives in the public sector is not likely to
result in cost
minimization."
The simple notion that government has no incentive to hold
production
costs down may be too strong, at least in the local government
context, because
local officials face competition from potential candidates and
communities
face competition from other communities for residents and
businesses. If gov-
ernment production costs for a service in one community are
higher than they
need to be, then taxes in that community also are higher than
they need to be.
As a result, households or businesses might move, as in the
Tiebout process (see
Chapter 5), to those communities with lower production costs
for a given level
of service. Similarly, candidates for public office could ma ke
the production
inefficiency an issue in the local election. Therefore, it may be
more accurate to
argue that the incentive to hold cost down is greater for a profit-
maximizing firm
than it is for a government but not completely lacking in the
latter. Essentially,
the contention is that economic competition is more effective
than political
competition.
The three potential sources of lower production costs for private
firms most
often cited are lower labor costs, better management, and more
research/develop-

ment and faster innovation of the results. Lower labor costs may
arise either from
lower wages (which means that the government was paying
wages higher than
necessary for a given skill) or from less labor input (which
means that government
was hiring unnecessary workers or that fewer workers are
needed with an alter-
native production method). A private firm may more readily try
out different pro-
duction approaches, whereas government may tend to stick with
the current
approach, given that change often creates substantial political
difficulties for local
officials. Better management or experimentation and innovation
with different
production methods may be the reason a given level of service
can be produced
with fewer workers. In addition, private firms may use retained
earnings
to finance research or to purchase new capital equipment, which
lowers unit
production costs, whereas government may not be able to
allocate tax revenues to
those purposes as easily, given the many competing demands for
a share of the
government's budget.
When Might Privatization Not Work Well?
The three most often cited potential problems with private
provision of govern-
ment services arise from the bidding process, the precise
specification of the con-
tract, and monitoring and enforcing the contract. First,

comvetitive bidding may
not provide the service at lowest cost to the contracting
government if there are
only a few (or even one) potential suppliers and the government
has a limited idea
about the level of costs. This might be the case especially in
rural areas or when the
production technology is relatively new. In addition, potential
suppliers initially
might offer a price to the government that is less than actual
production costs to
induce the government to adopt privatization or to win the
contract. Subsequently,
the contractor then would demand a higher price after the
government has
eliminated or dismantled its own production system. The chance
of such "low-
balling" in the bidding process may be reduced if the local
government requires
relatively long-term contracts.
The second potential difficulty with privatization concerns
specifying the ser-
vice to be provided in the contract. Earlier in this chapter, you
learned that the out-
put of a government service can be characterized by the inputs
used or by alterna-
tive measures of the produced output or final result, none of
which are unique for
a particular service. Characterizing output for some services is
particularly diffi-
cult when the government has multiple objectives. If society
and the government
are not certain what "good" education is and how to measure it,
for instance, how

can government contract for it? In the discussion about
producing education in
Chapter 19, the distinction between the average student test
score and the variance
of scores is emphasized. Getting the highest average test score
may require apply-
ing more educational resources to the better students with the
effect of reducing
the scores for the students at the bottom. As a result, the
variation in test scores
increases, which might contradict the distributional objective of
government pro-
vided education. It is difficult to think about how one would
begin to specify the
contracted output for police protection (a specified percentage
of different types of
crimes must be "solved"?) or fire protection (fires must be
responded to in X min-
utes with average damages limited to $Y?).
The third potential problem with private provision concerns
monitoring the ser-
vice quality provided by the private supplier and enforcing the
contract when
problems arise. Monitoring the performance of the private
contractor itself creates
costs, which may be substantial, for the government. In some
cases, new data may
have to be collected and analyzed. As one example, consider the
costs of the U.S.
Department of Defense in testing and evaluating weapons
produced by private
contractors to ensure they meet the contract standards. In
addition, there must be a
reasonable remedy if the supplier does not provide or stops the
expected service.

Suppose that the contractor underestimates the cost of
production so that the price
charged the government is not sufficient to cover all production
costs, resulting in
losses for the firm. If the firm simply stops providing the
service, the implications
could be serious in the case of many services such as police and
fire protection.
David Sappington and Joseph Stiglitz (1987) have termed these
contractual
issues "the need for and costs of intervention in the private
production process."
Figure 7.5
Privatization of
services to public
prisons
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10-
AND SERVICES CHAPTER SEVEN ■ COSTS AND SUPPLY
162
X 63
They suggest that government should consider both the
probability that interven-
tion will be necessary and the costs of intervening if necessary.
They conclude that
"two important elements of this calculation include the
complexity of the task
under consideration and the need for rapid adaptation to
unforeseen contingen-
cies. When the task is particularly novel and complex,

unforeseen contingencies
are likely to arise. If rapid adaptation to these events is crucial,
. . . public provision
is more likely to be the preferred mode of organization" (p.
581).
Experience with and Proapecta for Privatization
The available evidence shows that nearly all state—local
governments contract with
private firms to provide some final services to consumers or
intermediate services
to the government, but which services are contracted for varies
greatly among gov-
ernments. Donald Kettl (1993) reports that only two services
(vehicle towing and
legal services) were contracted out by at least half the local
governments surveyed
by the International City /County Management Association, and
only 15 of the
75 service categories were contracted for by at least one-third
of localities. According
to this survey and others, the other most common examples of
government con-
tracting with private firms include legal services; hazardous
waste disposal and
solid waste collection; vehicle leasing and maintenance; vehicle
towing; street light
operation; street repair; landscaping and grounds maintenance;
management of
public facilities such as stadiums/arenas and convention centers;
architectural,
engineering, and management consulting; ambulance and EMT
services; and some
public-health services, especially for mental health and drug
treatment. (The
detailed list is in Table 6.4.) In addition, government continues

to purchase most
intermediate goods from private producers.
Kettl notes that government contracting is more likely, as with
the preceding
examples, when that service already is commonly provided in
the private market.
In such cases, government provision of these services may not
be necessary when
private provision is already readily available. Conversely, only
a very small frac-
tion of state and local governments contract for traditional
programs central to
those governments, such as prisons, police service, fire
protection, traffic enforce-
ment, libraries, or water and sewage treatment. As a result,
privatization attempts
in these areas are among the most dramatic and controversial.
One area where privatization has been tried but remains very
controversial is
public safety. For many years, fire-protection service in
Scottsdale, Arizona, has been
provided by a private contract service. Although this case has
received substantial
attention and at least one study shows it to be less costly than
public protection, pri-
vate fire-protection service is mostly restricted to specialized
cases such as airports.
A 1997 survey of local governments by the International
City/County Management
Association (VVemtz, 1999) showed that only about 2.5 percent
of localities reported
providing fire prevention or suppression service through
contracts with private
firms. Public safety areas in which contracting with private

firms was used sub-
stantially included ambulance and emergency medical services
(a quarter to a third
of localities) and vehicle towing and storage (80 percent of
local governments).
Even more attention has been focused on the private ownership
or operation of
prisons, of which there are currently about 50 in operation
spanning 14 states
Note: Data based on survey respondents from 25 corrections
agencies in 22 states.
SOURCE: Reprinted with permission, Governing magazine,
copyright 1993, 1994, and 1995.
May 1993, p. 47.
(Lemov, May 1993). So far, most of these contracts have been
for detention centers
and minimum-security facilities, although there is some
movement toward
expanding the trend to higher-security facilities. Short of
actually operating pris-
ons, it is even more common for states to contract for private
provision of some
services in prisons, particularly health care, food service, and
rehabilitation and
education, as shown in Figure 7.5.
Many of the potential advantages and problems about
privatization discussed
previously are illustrated by the case of public safety. So far,
any lower costs from
private operation seem to have come mostly from lower wages
or benefits paid to

workers, but some firms are developing new educational or
work programs for
inmates. In establishing contracts, governments often try to
specify both cost lim-
its (often as a percentage of the cost at a state prison or a
limited rate of growth) as
well as performance measures to ensure that lower costs do not
arise simply by
providing worse conditions for prisoners. Governments that
have privatized pris-
ons believe that monitoring the actions of the contractor is
crucial and thus often
maintain a monitoring state inspector at the prison. Yet, serious
worries about lia-
bility remain. If an employee was seriously negligent, it seems
possible that both
the private contractor and the state could be sued. As a result of
the damages, the
private contractor could go bankrupt, leaving the state to pay
damages and to
absorb the costs of running the prison.
Poole and Fixler (1987, 619) argue that "four other functions
generally carried out
by government today are likely candidates for privatization in
the next decade: tran-
sit, highways and freeways, water supply, and education."
Private provision already
is used in all four of these areas to some degree. For instance, a
number of private
bridge firms have been employed, including the firm operating
the tunnel under
PART 111 ■ PROVISION OF STATE AND LOCAL GOODS

AND SERVICES ER SEVEN ■ COSTS AND SUPPLY OF
STATE AND LOCAL GOODS AND SERVICES
165 1
and the bridge over the Detroit River between Detroit and
Windsor, Ontario, and the
company operating the private toll bridge between Fargo, North
Dakota and Moor-
head, Minnesota. Both California and Virginia are
experimenting with private toll
roads that will compete with "free" public roads. Chicago, New
York, and other
cities have contracted out the collection of parking fees and
some traffic fines.
Privatization of education may turn out to be most
controversial, however. Edu-
cation already involves a mixture of public and private
provision in not only private
elementary and secondary schools but also private day care,
nursery schools, tutor-
ial services, and extracurricular activities (for example, music
and sports). But the
notion of additional privatization in education as usually
envisioned by its propo-
nents involves either private provision entirely or direct
competition between pri-
vate and public schools. Individuals could receive education
vouchers from the gov-
ernment that could be "spent" for any school desired. Thus,
government would
continue to finance a substantial portion of education through
taxes, but the educa-
tion service would be produced by private schools. Proponents
argue that the result-

ing competition would reduce education costs and/or improve
education results,
partly because students would select schools most appropriate
for them. Opponents
of more privatization in education usually cite concerns about
the distributional
effects if students become more sorted by ability or other
characteristics than they
are with the current system. Indeed, some have argued that a
diverse student mix is
essential to the socialization objective of education and are
concerned that there
would be less diversity with private education than with the
current public schools'
structure. If education involves such important externalities,
then public provision
may be called for. These issues are considered in further detail
in Chapter 19.
Substantial and increasing evidence also supports that the use of
private firms to
produce services has resulted in lower costs, especially for the
more typical types
of privatization. Kettl (1993) reports that 80 percent of
localities that tried contract-
ing out had cost savings of at least 10 percent (suggesting that
localities are select-
ing the correct services to contract for in aggregate). For
instance, studies by E. S.
Savas and Barbara Stevens (1977) and by James McDavid
(1985) have found that
public solid waste-collection services are 50 to 70 percent more
expensive than
equivalent private collection services. (This may not be too
surprising because
waste collection is entirely a private-sector activity in many

communities, suggest-
ing that there may be specific reasons why collection remains a
public service in cer-
tain areas). These cost savings almost all are labor savings
arising from more flexi-
ble methods of organizing and using workers or from paying
lower wages than
government or, most importantly, from providing fewer or
lower-level benefits.
From a different perspective, John Donahue (1989) argues that
any cost savings
and other benefits from privatization arise not so much from
contracting out per
se, but rather from competition. Greene (2002) stresses this
point as well. He notes
that the research about costs of residential solid waste
collection shows that gov-
ernment contracting with private firms is least costly, but that
an entirely open or
private system is most costly. This may suggest that substantial
monopoly power
may arise in an entirely private system. Having government
compete with private
producers—as well as the private producers competing with
each other—may
help maintain competition and keep costs lower.
overnrnents may be able to enjoy the benefits of economic
competition without
ntracting out by encouraging public agencies or divisions to bid
for projects
airist private firms or other public entities. In Rochester, New
York for example,
refuse collection workers changed their methods to keep costs

below those of a
.vate firm the city considered, contracting with. On the other
hand, contracting
y riot generate lower costs or better quality if there are few
private suppliers who
erefore have monopoly power (especially if competition from
public provision
is eliminated). For instance, Kettl reports that only two main
firms are involved
in hazardous waste disposal, and that requests for mental health
contracting in
Massachusetts drew only 1.7 proposals from private producers,
on average. With
few private suppliers and little competition in bidding, the
government has few
options if the contractor does not carry out the contract
satisfactorily. From this
perspective, the main focus of government officials should be
on developing and
maintaining competition among producers of government-
provided services.
Application 7.2
PRODUCING CITY FIRE PROTECTION SERVICES ?
cost, is the large variation in the number of fire
hydrants; on average, there were 85.6 hydrants
per square mile, although the standard devia-

tion was 50 and the range from 14 to 302!
Input prices also varied substantially. Compen-
sation cost per full-time employee (a weighted
average of salaries and fringes for a first-class
firefighter and a department captain) varied
from $27,000 in Springdale, Arkansas, to
$119,000 in Washington, D.C. An index of the
cost of building and operating a fire station in
these cities varied from 76 to 114, with an aver-
age of all the city values equal to 96.
Economists would suspect that the amount
and type of inputs selected by these depart-
ments would be influenced by input prices.
Getz reported that the elasticity of labor per
square mile with respect to the wage was
-36; cities with higher wages used fewer fire-
fighters per square mile, although demand is
relatively inelastic. Interestingly, cities with

higher wages also used fewer stations and
trucks per square mile. Apparently, these fire
'See Getz (1979).
In a classic example of detailed examination of
a single service, Malcolm Getz (1975) surveyed
371 central-city fire departments about inputs
and production methods, costs, city character-
istics, and results. The survey resulted in usable
data from 187 different cities covering 44
states plus the District of Columbia. Many
other state-local government services have
been studied also (transportation and educa-
tion are discussed in subsequent chapters),
but this detailed examination of fire protection
provides an especially interesting example of
many issues discussed in this chapter.
Getz discovered great diversity among
these city fire departments in the amount and

types of inputs used to produce fire protec-
tion. On average, each fire station served an
area covering three and one-half square miles,
although the range was from one station for
one square mile to one for nine square miles.
Similarly, there were 6.8 firefighters per station
on average, with a range from 3.3 to 11.6. Per-
haps even more interesting, given their low
Application 7.2 — Producing City Fire Protection Services
departments attempted to keep the amount
of firefighters and trucks per station constant
and responded to higher wages by decreasing
use of all three. Getz also found that the
amount and mix of inputs depended on city
characteristics. Cities with older housing tend-
ed to use more of all inputs, cities with more
manufacturing used relatively more aerial

trucks compared to pumpers, whereas cities
that had more business than residential activ-
ity also used more of all inputs.
Getz attempted to measure how variations
in inputs influenced the effectiveness of the
fire department but found very little statisti-
cal relationship between additional inputs
and improved output. Fire-department out-
put was measured by number of fires per
1,000 houses and per 1,000 commercial and
residential employees, by the dollars of dam-
age per fire, and by the number of civilian fire
deaths per million population. Two results
that did appear were that more fire-code
inspectors decreased the number of multi-
family house fires and that more stations per
square mile decreased the amount of dam-
age per industrial fire. In the statistical work,

both the number of and damage from fires
were mostly related to the age of structures in
the city—cities with older structures had
more fires and more serious fires.
The premise of the Baumol hypothesis is that
productivity improvement is difficult to achieve
for some services, state-local government ser-
vices included. But Getz did find some major
technological changes in the methods and
equipment used in fire fighting. Among meth-
ods, upon arriving at a fire, a department must
choose whether to first run water-supply hoses
from the nearest water supply or to immedi-
ately attack the fire using a relatively small
amount of water carried in a pumper truck.The
latter method, called a "booster attack," was
introduced around 1922 and is now routinely
used by more than half of the departments.

Technological changes involving equipment
include use of breathing apparatus (first used
in 1940); power saws for quick access (1958);
chemicals added to water for fighting flam-
mable-liquid fires, called "light water" (1956);
and a quick-connect hose coupling (1964).
One other major attempt to increase pro-
ductivity and lower costs of fire (and police)
protection has been the creation of consoli-
dated public safety departments to provide
both fire and police functions. 8 Some depart-
ments are fully consolidated with all duties
performed by public safety officers, others
perform dual duty only for some services or in
limited geographic areas, and still others are
consolidated only at the administrative level.
Crank (1990) reported that only 1 to 2 percent
of local police and fire services are provided

through consolidated departments, with the
middle 1970s the most common period for
initial consolidation. Not surprisingly, consoli-
dated service tends to be more common
among smaller localities where there are
potential cost savings from economies of
scale. Because of quality concerns about
training of dual-service personnel and eco-
nomic concerns about appropriate wages
and benefits, some states and localities have
forbidden such a production arrangeme nt.
Therefore, it appears that some productivity
improvement has occurred in producing fire
protection, but it is not clear that the gain has
been sufficient to prevent cost increases nor
that all such possibilities will be embraced.
Application 7.3
PRIVATIZING ENTIRE STATE DEPARTMENTS 9

Governing Magazine reported about an
attempt in Texas to take privatization in a new
and much more expansive direction than has
been used in the past. As previous discussion
in this chapter suggests, most privatization by
the state-local sector is applied to purchases of
specific inputs used by the government (such
as motor vehicles) or to very specific, direct
services (such as health care in prisons or com-
puter systems programming). But Texas is now
exploring the option of consolidating state
departments and contracting as much of the
operation of those departments as possible.
A recent law directs the Texas Health and
Human Services Commission to consolidate 12
health and human service agencies into 4 and
then to seek private sector operation of as
much of the work of those agencies as possible.

If implemented, the Commission would serve
the continuing political or traditional role of
state government, contracting with private
firms to undertake the day-to-day work of the
agencies. The initial intent is to contract with a
private firm to establish a call center staffed
by private employees who would evaluate the
circumstances of individuals and determine
whether and what benefits they might be eligi-
ble for. So, rather than visiting the local office of
the state human services department to apply
for specific benefits, the individuals would tele-
phone the center and have those decisions
made by the contractor. As this approach is
expanded, the state is on the verge of transfer-
ring substantial operational decisions—and
perhaps even policy decisions—to individuals
who are not state employees but contractors.

The goal, it seems, is to be more efficient—
to deliver more service at constant cost or
constant service at lower cost.
Expanding privatization in this manner
clearly is controversial and will be watched
closely. It may or may not turn out to be a
mechanism to reduce costs. Imagine, if you
will, not going to your local school for class
taught by a teacher employed by the school
district. Instead, students go to Language, Inc.
for Spanish class, Math R Us for math class,
and so on—each provided by a private con-
tractor hired by the school system. That is the
nature of the issue.
AND SERVICES
"See Crank (1990).
CHAPTER SEVEN • COSTS AND SUPPLY OF STATE AND

167
SUMMARY
The output of state–local governments can be measured in at
least three different,
broad ways. Output can be measured (1) by the amount of
money spent by a gov-
ernment on a service, referred to as expenditures; (2) by the
amount of directly
produced output provided by the government; and (3) by
results—the level of
consumption enjoyed by citizens.
State–local governments purchase inputs such as labor services,
capital goods,
and materials and supplies and combine then in some way to
provide public facil-
ities or what is called directly produced output. The cost of the
directly produced
'See Walters, Jonathan. "Going Outside." Governing Magazine,
May 2004, pp. 23-29.
AND SERVICES
168
output, which depends on the production technology and the
prices of the inputs,
is the expenditure of the government on this service.

The service result, called the consumer output, depends on the
directly pro-
duced output provided by the government, on the private
consumption decisions
of individuals, and on the characteristics of the community and
the population.
If the prices of inputs rise, then it will cost governments more
to provide the
same produced output. And if input prices differ for different
subnational juris-
dictions, equal expenditures by different jurisdictions do not
necessarily translate
into equal produced output.
Expenditures for direct-labor services represent about half of
the expenditures
by state-local governments on average. State-local governments
are also one of the
largest employers in the economy, employing about one of
every seven employees.
Baumol argued that productivity increases in some sectors of
the economy
would force wage increases throughout the economy, increasing
the production
costs in those sectors where productivity improvements do not
occur. The nature
of some state-local government services precludes productivity
gains because the
essence of the service is the labor itself. For those services, unit
production costs
would certainly increase, and the choice for consumers is either
to substantially
reduce consumption of the service or to spend ever-increasing
amounts to contin-

ue consuming current levels.
DISCUSSION QUESTIONS
1. "If one city spends more on police-protection services per
capita than does
another, one expects less crime in the first city than in the
second." True,
false, or uncertain? Explain.
2. At a public-budget hearing, a citizen once argued, "Education
expenditures
have increased 5 percent in each of the past three years even
though
student enrollment has been declining. Where is the extra
money going? It
seems to me that if the number of students declines,
expenditures should
also decline." Is the citizen right or wrong?
3. "If the Baumol hypothesis is correct concerning local
government finances
and if the price elasticity of demand for local services is
inelastic, then
we are in trouble—eventually, spending for education, police
and fire
protection, and sanitation will require half of our incomes."
Evaluate this
concern. What changes could occur to prevent this from
happening?
4. Competing with private-sector salaries is a common problem
for some
academic departments in universities, particularly in
engineering,
accounting, other business fields, and biological science. If

universities do
not match the salaries, they may be unable to hire professors, or
at least the
better candidates; if they do match the salaries, then the cost of
operating
those programs (and eventually tuition) will increase. How
might
universities change the production of engineering or business
education to
cHA g SEVEN ■
SERVICES
169
problem—that is, how could professors be substituted for or
made
aoudid
ietYin
this re productive? Do you think those changes would affect the
„
or nature of education in these fields? Does this problem apply
to
as well as public universities?
SELECTED READINGS
Baunio, William. "Macroeconomics of Unbalanced Growth: The
Anatomy

of the Urban
Crisis." American Economic Review,
62 (June 1967): 415-26.
Bradford, David F., R. A. Malt, and Wallace E. Oates. "The
Rising Cost of Local Public
Services: Some Evidence and Reflections." National Tax
Journal, 22 (June 1969):
185-202.
Greene, Jeffrey D. Cities and Privatization. Upper Saddle River,
N.J.: Pearson
Education,
2002.
Hirsch, Werner. "State and Local Government Production." In
The Economics of State and
Local Government. New York: McGraw-Hill, 1970,147-65.
Kettl, Donald F. Sharing Power: Public Governance and Private
Markets.
Washington: The
Brookings Institution, 1993.
Pack, Janet Rothenberg. "Privatization of Public-Sector
Services in Theory and Practice."
Journal of Policy Analysis and Management, 6 (Summer 1987):
523 -40.
Page 1Page 2Page 3Page 4Page 5Page 6Page 7Page 8Page 9Page
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Published by Articulate® Storyline www.articulate.com
Key Aspects of Financial Management
Intro
Welcome
Notes:
Instructor
Notes:
Hello, this is Matthew Stefanak. In this key aspects of financial
management course, we're
going to discuss budgeting and some of the sources of revenue
and expenditures associated
with health services organizations, including those that provide
clinical services. The course
will provide a high level introduction to Financial Management
concepts and skills like

managing a budget, and will also expose you to financial
performance improvement tools in
more depth. During the course, you'll have the opportunity to
complete two exercises that
will help you improve your ability to modify a budget for a
health services organization to
accommodate changes in projected revenue, and to complete a
cost analysis for health
services to assure that your organization can fully recover the
cost of providing services. You
will need to have some basic skills in Excel or some other
spreadsheet software in order to
complete the module exercises.
Learning Objectives
Notes:
The learning objectives for this course are to list the key steps
in the budget development
process, identify expenses that must be accounted for in line
item budgets, utilize budget
reports to track and manage financial performance, identify
relevant recoverable costs for
health services programs, and apply basic cost analysis tools to
assure that health services
organizations can recover their costs for providing services.

1. Financial Management and Budgeting Basics
1.1 Financial Management
Notes:
1.2 What is Financial Management?
Notes:
So let's begin with a definition of financial management. It's a
process of providing oversight
of the health service organization's day-to-day financial
operations. Planning the
organization's long range financial direction, both internal and
external, and increasing the
organization's revenues and decreasing its cost, the bottom line,
essential for sustaining
organizational growth in both for-profit and not-for-profit
health services organizations,
including health departments.

1.3 Major Objectives of Financial Management
Notes:
The objectives of financial management of health services
organizations are to generate a
reasonable net income, that is, assure that revenues exceed
expenses, set prices for services
by conducting cost analyses, and sometimes through negotiation
with third-party payers,
such as private health insurers, or employers seeking services
from your organization.
Record and analyze cost information that's used in budgeting,
and cost analyses. Prepare
audit and disseminate the organization's financial reports for the
governing body, managers,
external stakeholders like grant-making organizations, and the
public for public sector
organizations. And also invest in long-term capital assets. This
objective is less relevant for
public health agencies, which have fewer physical assets.
1.4 More Basic Objectives
Notes:

Several more basic objectives of financial management are to
ensure that payroll is covered
and that suppliers are paid. In other words, make sure the bills
are paid. Protect the
organization's tax status by documenting the organization's
community benefit. This applies
to private not-for-profit organizations. This is an important
function but we will not be
discussing it in detail in this course. Respond to external
stakeholders such as government
regulators, external auditors, accrediting agencies, and grant-
making agencies, and control
and reduce financial risk to the organization through internal
controls. Internal controls are
the mechanisms, rules and procedures implemented by an
organization to ensure the
integrity of financial and accounting information. It promotes
accountability and prevents
fraud.
1.5 Tax Status of Health Services Organizations
Notes:
Health services organizations may be public or private, and may
be for-profit or not-for-
profit. For-profit investor-owned health services organizations

serve private interest and pay
taxes. Their goal is to maximize profits for the owners. You
may have observed that many
hospitals in the United States have transitioned from not-for-
profit to for-profit status in
recent years in response to health care cost containment
pressures and the increasing cost
of new health care technology that smaller community hospitals
have been unable to bear.
Not-for-profit health services organizations serve public
interests and are tax exempt. Their
goal is to provide community benefit and optimal patient care
including care to the indigent.
There are two types of not-for-profit health services
organizations. Business-oriented or
private and public, or government-owned. Although they are
not-for-profit they must also
turn a profit. In other words, their revenues must exceed their
expenditures in order to
sustain themselves and grow.
1.6 The Budget as a Plan
Notes:
So, let's turn to the definition of a budget. A budget is basically
a plan. It's expressed in terms
of planned activities and projected revenues and expenses. The
budget is statement of
anticipated results, for example, expected revenue, a basis for
future or continuing plans
and a statement of intended accomplishments. It's more than a
forecast or a guess.

1.7 The Budget as a Control Tool
Notes:
The budget is also a control tool. As a control tool, the budget
provides accountability to
those in the organization who have fiduciary responsibility. It's
a basis for monitoring the use
of resources and a basis to measure actual performance against
the budget plan.
1.8 For Sound Budgeting
Notes:
There are certain conditions necessary for sound budgeting in a
health services organization.
First, there has to be a sound organizational structure with clear
budget responsibility. A
consistent defined budget period, it's based on a fiscal year,
which may be different from the
calendar year. The collection of adequate data to track
performance. A reporting system that
reflects the organizational structure. In other words, the
appropriate persons in the chain of

command share these reporting responsibilities. There's a
uniform chart of accounts
developed by Health Services Management Professionals, and
widely used in the industry. A
UCA or Uniform Chart of Accounts is the standardized system
to measure and report the
cost of health services. You'll have the opportunity to learn
more about a uniform chart of
accounts for public health agencies in another course. Finally,
there's an audit system for
timely explanation of variances that's been implemented.
1.9 Test Your Knowledge
Notes:
Account codes used in a uniform chart of accounts are typi cally
developed by: C. National
Associations of Healthcare Financial Management
Professionals, such as the Healthcare
Financial Management Association. A. Uniform chart of
accounts for public health agencies is
under development.

2. The Budgeting Process
2.1 The Budgeting Process
2.2 Budget Periods
Notes:
Budget periods are operating budget cycles, often referred to as
periods. They're usually for
a 12-month period. Organizations may have multiple budget
periods depending on the
funding source. Capital or special project budgets may be for
longer periods than 12 months.
2.3 Budget Designations
Notes:
The operating budget is what you're most likely to be

responsible for, if you work as a Health
Services Program Manager. As such, you will be responsible for
projecting and tracking
revenue and expenses for your program or department within
the organization. You may
also be responsible for obtaining costs for capital expenditures
such as equipment. Most
health departments do not have capital budgets.
2.4 Budget Process: Initial Preparation
Notes:
The budgeting process usually begins with direction from
organizational leadership or an
external funder such as a grant-making organization about what
are the budget priorities
and overall resources available for the next budget period.
Program managers are then
responsible for developing detailed projections of revenues and
costs based on these
priorities and projected resources.
2.5 Budget Process: Review and Approval

Notes:
Budgets proposed by department or program managers are
reviewed by senior
management who may make changes based on the need to fairly
allocate limited resources
among the organization's programs and services. In public
organizations such as local health
departments, the budget will be subject to public review by
appointed or elected officials
serving on or overseeing the organization's governing body.
2.6 Budget Justification
Notes:
Budget proposals must be accompanied by supporting
documentation, usually including a
narrative that justifies particular line items in the budget. Grant
making organizations will
often demand these kinds of budget justifications from grant-
seeking organizations.
2.7 Budget Process: Implementation

Notes:
Once a budget is approved, it is then subject to monitoring and
reporting requirements.
Budgets may need to be cut or frozen if revenue or expense
projections vary significantly
from the budget plan. Different audit requirements also apply,
depending on the amount
and the source of revenue and the type of health services
organization.
2.8 Major Budget Revenue Categories
Notes:
In any budget, there are major budget revenue categories. Not-
for-profit, governmental
health services organizations, such as local health departments,
will depend on revenue
from multiple sources, including property taxes, state and local
government appropriations,
for example, general revenue funds, as they're sometimes called,
voter lab base, fees for
clinical services, including reimbursement from third-party
payers, like Medicare, Medicaid
and private insurance and out-of-pocket payments from clients,
license and permit fees for

regulatory programs, such as food service licenses. State and
federal categorical block ran
and contracts such as those for maternal and child health
services, or a public health
emergency preparedness, private foundations often provide
funding, and other not-for-
profit health services organizations may also receive revenue
from many of these same
sources. Revenue sources are usually categorized as restricted
or unrestricted revenue
depending on conditions placed on their expenditure by the
revenue source.
Notes:
A Federally Qualified Health Center, or FQHC, is an example of
a city not-for-profit, private
health services organization. An FQHC is a private not-for-
profit healthcare provider that
receives federal funding and bills both public, that is Medicaid
and Medicare, and private
health insurers as well as its patients paying out of pocket.
3. Budget Expenses

3.1 Budgeting Expenses
3.2 Major Budget Expense Categories
Notes:
Here are the major budget expense categories you will see in an
operating budget. In health
services organizations like health departments, the largest
category for budget line item by
far is personnel, accounting for 85% of expenditures in many
organizations. Capital and
indirect costs may also be significant in a larger organizations.
In addition to personnel-
related expenditures, there are a budget line items for supplies,
contracts, travel, training
and these are all typical line items found in a budget.
3.3 Direct vs. Indirect Costs
Notes:
It's important to distinguish between direct and indirect costs in
budgeting. Direct costs are

those that would not otherwise be incurred by the organization
if the program did not exist,
such as program salaries, services and contracts, dues and
subscriptions, and equipment.
Indirect costs are associated with the entire organization that
are prorated by program or
department. For example, telephone or internet charges and
housekeeping.
Notes:
Which of the following is an example of an indirect cost for
healthcare services? A: Water
used during a clinic visit. This is a cost that the organization
would incur even if the program
didn't exist. It is pro-rated to the program on some basis, such
as the number of program
employees as a percentage of total employees in the
organization.

This seemingly straightforward task, however, is fraught with

This seemingly straightforward task, however, is fraught with

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