Rewards: A Market-Driven Framework for Government Provision of Public Goods

 

Author: Kevin Cox and Heather Caufield

 

 

The success of Rewards programs such as frequent flyer and buyer schemes or international carbon credit programs have laid down a blueprint that can be readily adapted to create a new, viable means of financing government investment in Public Goods through revenue generated from current consumption of related goods. The Rewards methodology provides a framework for governments to influence consumer behaviour, direct funds to what they believe are desirable ends and to use market mechanisms to manage the distribution of these funds. This paper discusses ways in which public authorities could implement such programs, using the examples of Rewards to reduce consumption of water and to reverse greenhouse gas emissions.

 

Public Goods are items or services that share two main characteristics: non-excludability, meaning that if the good is available to one, it is equally available to all; and non-rivalry, such that consumption by one entity does not reduce the capacity for another to consume it or benefit from it. A good example is the air we breathe. It remains freely available to all and regardless of how much air one person consumes, it in no way impinges on the availability of air for others.

 

Other often-quoted examples include the defence of a nation, traffic lights and street lighting, and the content of copyright. Global Public Goods, as the phrase suggest are public goods that are not confined by national boundaries, such as peace, health, and financial market stability.

 

On the other side of the coin are Public Bads, where the consumption of some private goods causes an external effect resulting in the cost of the effect being born by the community rather than the consumer. The most common examples are grouped under the term ‘pollution’, whether it be clean air, greenhouse gases, roadside rubbish, plastic bags, destruction of the habitats or salinity.

The production of Public Goods and the alleviation of the effect of Public Bads require investment and the allocation of resources. The problem however arises in determining who pays to provide these goods and services.

 

A Question of Funding

 

By definition when a public good becomes available, it is available to all. For example, where streetlights exist they benefit the entire community. The concern for those funding Public Goods is that without rules and ways of enforcing the rules, some in the community will receive the benefit of the Public Good without paying their fair share. These consumers are known as Free Riders.

 

The existence of Free Riders acts as a deterrent to private sector investment in Public Goods. Why invest when you will not reap a full return? Worse, if only a limited number of consumers pay their share, the investment may fail to break even. The result is underproduction or no production of the public good.

 

There are numerous strategies for minimising the negative impact of Free Riders including:

  • dominant assurance contracts, in which participants agree to contribute to a Public Good investment on the proviso that a guaranteed minimum level of contributions is reached;

  • the Coasian solution, under which potential beneficiaries of the Public Good combine resources;

  • appeals to public spirit and morality;

  • funding by privileged groups, those entities that will gain most from the provision of the Public Good;

  • privatisation, or the merging or buying out free riders;

  • legislated exclusion of free riders, if feasible1.

 

None completely remove the issue of Free Riders but they do offer ways to improve the viability and attractiveness of Public Goods investment.

 

There is yet another method of funding Public Goods which comes under the broad heading of advertising. That is, where the consumption of a Public Good – such as free to air TV – may result in the purchase of an excludable and depletable good. Advertising is used in news and other information services where the production of information is paid for from the selling of advertising. If the conflicts of interest inherent in the mixing of advertising and information services can be overcome this can be a viable method of funding.

 

 

The Role of the Public Authority

 

The most common approach to the supply of Public Goods and the alleviation of Public Bads is government provision, either through complete government funding or via subsidies.

 

While public funding is the simplest and seemingly the most administratively straightforward it introduces inefficiencies because of the difficulties in determining the allocation of funds to Public Goods, who pays what, and how and where the funds are distributed. With government allocation and control of funds, most of these decisions are made through political and administrative processes rather than market-based and behaviour modification solutions.

Various methods are introduced by governments to assist in allocation, one of the most widespread being “user pays”, where agencies introduce a requirement for partial or full payment for services by consumers and establish exclusion through waiting lists and other rationing devices. Australian guidelines for conduct of government agencies implementing user pays programs were established in the National Competition Council’s (NCC) “Competitive Neutrality Reforms” review of the mid 1990s. Since then the take-up of user pays schemes by Federal, State and Local government authorities has made the user pays philosophy an expected, if not always accepted, part of the Australian Public Goods landscape.

 

The Australian health system is an example of this method, where some of the cost is borne by the user, with health insurance organisations forming a buying cooperative to act for the user. The remainder of the health cost is met by the government, which attempts to control over-servicing.

 

Unfortunately, the user pays economic model frequently falters on a number of counts. It offers little opportunity for consumer choice, the lack of which removes much of the stimulus for market growth and development. It has limited behaviour modification effect, as there is little positive encouragement to change habits. In the health system example, consumers are subjected to the same incentives regardless of whether they are publicly or privately insured, leaving little motivation to pursue one option over another and encouraging Free Riders.

 

A Queensland Parks & Wildlife Service study into best practices within user pays programs noted that such systems can offer government agencies and their customers a number of benefits providing they follow careful design, clearly stated objectives and they achieve cost-effectiveness. However, the study also found that “few agencies were able to give accurate or even rough estimates of the cost-effectiveness or profitability of their user-pays operations. Costs of revenue collection and system administration were generally not known.”2

 

An alternative range of allocation methods that are also designed to restrict consumption may be grouped under the general topic of derivation markets that introduce some market forces. With derivatives, non-cash instruments of exchange are established, in effect becoming a rationing method for Public Goods. Common examples are food stamps, carbon credits and school vouchers or scholarships. These instruments are alternatives to cash and are used by governments to channel expenditure. They introduce choice and a market, allowing restricted options in where the derivatives can be spent.

 

Derivatives increase the flow of money into a particular Public Good and allow distribution of the benefits to a targeted audience. Proponents argue that even limited choice results in active consumer participation and a healthier market. Those against cite concerns that funding of derivatives will be to the detriment of the overall investment in a Public Good, and that a restricted market will naturally become more expensive, with costs rising to take advantage of government subsidies.

 

Current schemes for the funding of Public Goods are far from ideal, as they tend to leave everyone unhappy. Those that include some market component work best but some that purport to be market driven are often distorted markets because either there are not enough sellers, not enough buyers or not enough choice to optimise the allocation of funds.

 

Consumer Preferences

 

A further consideration for any funding model that offers a degree of choice is the influence of consumer preference on spending behaviour.

 

Recent economic thought from U.S. economist David George3 suggests that there may be two kinds of consumer preferences: first-order preferences, which are influenced by immediate demands or circumstances, and second-order preferences, typically involving a greater depth of thought and reflecting the preferences we would like to have or feel we ought to have. The former provide the impetus for impulse purchases and cost-based decisions. The latter tend to be more morally and socially oriented and are most likely to be of influence in appeals for funding of Public Goods.

 

If public authorities can tap into consumers’ second-order preferences when devising Public Good funding schemes, they stand a greater chance of achieving consumer responsiveness and reaching their policy goals.

 

The Rewards methodology

 

Within the private sector, a common method of encouraging and directing consumer behaviour is to use marketing rewards such as “Frequent Flyer points”, the promise of “four cents off per litre” or the gift of a free cup of coffee on every fourth visit.

 

These marketing rewards offer consumers the opportunity to earn a bonus in return for a desired outcome (such as reaching a certain level of expenditure at the one retail outlet). They are structured so that they may only be spent in designated ways that encourage loyalty (or repeat business), further benefiting the sponsoring company. Loyalty programs are becoming ubiquitous in many markets as they can be very effective and are popular with consumers.

 

The Public Goods Rewards methodology combines elements of private sector loyalty programs with public sector derivatives and user pays programs to create a framework for government provisioning of Public Goods and the alleviation of Public Bads. It creates a framework to implement Elkington’s Triple Bottom Line for Public Goods.4

 

It provides governments with the ability to direct and encourage change in consumer behaviour while ensuring that the most economically efficient method of providing the Public Good is obtained through a market approach to financing the Public Good.

 

The aim is to offer governments a level of control over policy and consumer behaviour in the provision of Public Goods, leaving it to the market to manage and optimise the allocation of resources.

 

The methodology is as follows:

  1. Define the desired outcome as a policy statement

  2. Define measures to know when the desired outcome is achieved.

  3. Determine the desired behaviours to help achieve the outcome

  4. Devise a negotiable instrument (the Reward) that helps achieve the outcome

  5. Fund the negotiable instrument with the consumption of a related first-order preference good

  6. Specify capital projects in which Rewards may be invested, helping individual consumers to achieve their second-order preference objectives

  7. Measure the outcomes and tune parameters to achieve the objective

 

Step 1 will typically involve a Public Good that appeals to second-order preferences, such as public health or availability of education.

 

Step 2 is some measure that tells whether the second-order preferences are being achieved. It could be an increase in environmental flows of water, or a reduction in the greenhouse gases in the atmosphere.

 

Step 3 identifies the consumer behaviours or activities that need to be encouraged or altered to achieve the desired outcome. Such things might be riding to work, or reducing the amount of water used for a garden.

 

In Step 4, the negotiable instrument or Reward will vary according to the desired outcome but could include existing derivative-style mechanisms such as scholarships (encouraging access to education), food stamps (reducing the ill-effects of poverty) and carbon credits. Rewards should be designed to appeal as a mechanism for the transfer of funds between consumers rather than a punitive tax. Rewards are used instead of cash because they offer a way of directing funds towards the desired outcome.

 

In Step 5 a way is devised of funding Rewards through charging more for undesirable behaviour. There are often existing mechanisms in place to achieve this such as higher prices for extra water or carbon credit taxes on greenhouse gases.

 

In Step 6 it is important to try to get Rewards to be spent on investment rather than consumption. Most second-order preferences require ongoing investment to achieve. For water sustainability it could be investment in ways of saving or recycling water. It is also important to make Rewards transferable so as to create a market in Rewards. This will free up funds for those people who think they can spend Rewards in an economically efficient manner to achieve second preference goals. This in turn creates a capital market for second-order preference technologies such as windmills, solar cells or tidal power.

 

Markets exist where there are many buyers and sellers, and buyers can make choices as to where they spend their funds.

 

Using Rewards rather than a general currency is important because Rewards will rarely be worth their face value when converted to cash. By restricting their use to specific investments we create a market and the money will not “leak” to other activities.

 

While it could be argued that governments can allocate taxes collected from greenhouse gas emissions to worthy projects, this does not create a market. It is important to give Rewards to as many people as we can because this then creates many buyers. Most well-meaning taxes collected for specific purposes end up in consolidated revenue and are used for other purposes – which, while worthy, should not be paid for from taxes collected for a particular reason.

 

Schemes such as envisaged in this essay have been difficult to implement until recently. Technology has made Public Goods Rewards practical because of the spread of the Internet, because of public acceptance of this technology and because of the computing power needed to handle the transactions. Common currency is an artifact of necessity because it has been the only efficient way to devise a negotiable instrument. However, the advent of electronic money brings with it the possibility of tagging these new currencies and associating behaviours with the money itself.

 

It is believed that the idea of tagged money can be extended to bring the idea of markets into areas where previously deemed impossible, such as peace between populations – but that is the subject of another essay.

 

The concepts of Public Goods Rewards can be introduced in any society at any level of grouping, providing the members of the group accept the rules and acknowledge the worth of the Rewards. It can be at a household level through to the United Nations.

Example 1: Sustainable Water Use

 

In recent years, water has become one of the most newsworthy Public Goods in Australia. The ongoing drought and rationing have helped to create a high level of awareness among consumers resulting in a widespread acknowledgement of the need to introduce more sustainable practices.

 

Turning that acknowledgement into action requires education and cooperation from water consumers. It requires continuous capital funds investment to develop recycling and water saving systems, which on their own are not economically viable when they compete with free rain.

 

Following the methodology outlined earlier, a Public Goods Rewards program for sustainable water use would be as follows:

 

  1. Establish an objective such as removing the need for urban communities to be subjected to water restrictions and ensuring an increase in water flows in natural waterways to an environmentally appropriate level.
  2. Establish ways of measuring the outcomes. In this case it may be the removal of the need for urban water restrictions and the increase in the flow of the inland water systems to an environmentally appropriate level.
  3. Determine desired behaviours such as reducing unnecessary water consumption for toilets, showers, garden watering, dish and clothes washing.
  4. Create Water Rewards, transferable vouchers awarded to individuals who achieve a predetermined reduction in water consumption. The vouchers may only be spent on ways to further reduce water consumption, either within the home or in the community.
  5. Finance for Water Rewards would come through consumer water usage charges, with those demanding more water paying a higher premium than those using less than a pre-determined, sustainable quantity.
  6. Establish a market for Water Rewards, restricting redemption of the vouchers to equipment and services that further reduce water consumption or give ways of increasing supply through water tanks, grey water reuse, recycling schemes, wet land projects, cloud seeding or even desalination plants, either within the home or in the community. A portion of the funds from the sale of the water could also be retained by the water authority for investment in water conservation measures or water infrastructure.
  7. Measure the results and see if the objectives set are being achieved. If they are not then increase the cost of excess water, increase the rewards, and open up the market to better ways to spend rewards.

 

The system would not mandate how water conservation is to be performed and would make no recommendations on the methods used. It would simply offer economic incentives in an equitable and politically acceptable manner.

 

In addition to achieving the primary outcome of a reduction in water use, a Rewards program would provide funds for water-related infrastructure projects. The process offers incentives to assist first-preference decision making as well as appealing ethically and morally, giving weight to consumers’ second-preferences.

 

A self-funding program that could be offered in any community that has metering of water, its success or failure would easily be determined by measuring the decrease or otherwise in water use following the introduction of Rewards.

 

 

Example 2: Reducing Greenhouse Gases

 

Related to the concerns surrounding water, greenhouse gas emissions and their impact on global warming are becoming major issues for governments around the world. Carbon credits and taxes are part of the solution but it is apparent that these measures alone will not solve the problem. With climate change already being experienced, the imperative is for public authorities to begin thinking in terms of negative emissions rather than just a reduction in emissions.

Using the Public Goods Rewards methodology, a government looking to act on reducing the amount of greenhouse gas in the atmosphere may define a desired outcome as ‘the funding of research into ways of increasing natural carbon fixing mechanisms and creating energy sources that remove more greenhouse gases than they put into the atmosphere”.

Existing carbon credit schemes may provide funds for research and development but there remains the need for a market mechanism to direct the flow of funds. In addition, consumer behaviour needs to change if there is to be any hope of removing greenhouse gases from the atmosphere.

 

Greenhouse Gas Rewards would offer public authorities a means of using the money raised through carbon taxes in a positive feedback loop, providing incentives for consumers to change their behaviour while stipulating that the rewards earned must be spent on greenhouse gas reduction investments.

 

This could be achieved by converting carbon taxes into rewards for people demonstrating low greenhouse gas behaviour. For example, a person would earn rewards for buying a public transport annual ticket, by not owning a car, by using less than the average amount of energy per person in their house and so on.

 

As with the Water Rewards example, Greenhouse Gas Rewards would have a value, meaning they could be transferred or sold but they may only be spent on greenhouse gas reducing technologies or activities. Examples include growing trees, developing bio fuels, fixing carbon from the air, or the purchase of solar cells.

 

This approach will produce a virtuous feedback loop. Those people saving greenhouse gases will be rewarded with funds that they can only use on ways of saving more greenhouse gases. Importantly it provides a market mechanism to direct carbon taxes to the technologies that give the best commercial return while still reducing greenhouse gases.

Furthermore, such a system triples the economic effect of the single carbon tax. It provides a disincentive to use dirty energy; a reward for changing behaviour to use clean or no energy; and a source of investment funds to produce energy in less polluting ways as well as funding research into techniques to actually reduce greenhouse gases in the atmosphere. For example, research into biological mechanisms to “eat” CO2 could give a payout from the payment to the inventors and developers of the CO2-eating techniques by allowing rewards holders to invest in the company that implemented the solution. The company would be paid from carbon credits and the people who invested their rewards would be paid in dividends from the company.

Conclusion

Simple market mechanisms based on first-order preferences are unlikely to provide a solution to funding Public Goods and removing Public Bads. Public Goods provision is almost always related to second-order consumer preferences. Rewards based systems offer a means to reward second-order preference choices and give ways of financing the infrastructure needed through market mechanisms to achieve policy objectives. The systems created are fair, equitable but still harness the magic of markets to achieve the economically best allocation of funds. The systems are tunable to give the desired policy outcomes because the levers of control still reside with governments. The systems can be applied to almost any policy outcome that requires the provision of Public Goods.

 

Notes:

The Wikipedia: http://en.wikipedia.org/wiki/Public_goods

2 Queensland Parks & Wildlife Service February 2000 Benchmarking and Best Practice Program User-Pays Revenue A report to the ANZECC Working Group on National Park and Protected Area Management http://www.deh.gov.au/parks/best-practice/reports/user-pays/results.html

 

3 George, D 2001 Preference Pollution, University of Michigan Press

 

4 Elkington, J. 2003, Cannibals with Forks: the Triple Bottom Line of 21st Century Business. http://www.amazon.com/Cannibals-Forks-Business-Conscientious-Commerce/dp/0865713928

 

References:

 

Coulson, A J 2003 The Citizen’s Guide to Education Reform http://www.schoolchoices.org/index.html

 

Edentiti Pty Ltd, Sustainable Water Project http://www.getmail.com.au/design/water/water.html

 

Groves, Theodore & J Ledyard 1977 Optimal Allocation of Public Goods: A Solution to the “Free Rider” Problem, Econometrica, Vol. 45, No. 4, pp. 783-810

 

Hamilton, C The Worldview Informing the Work of the Productivity Commission: A Critique speech to a Productivity Commission Retreat: May 11, 2006

 

International Task Force on Global Public Goods Meeting Global Challenges 2006 International Cooperation in the National Interest

 

Long, R T Autumn 1994 Funding Public Goods: Six Solutions, Formulations: Autumn 1994

 

Olszewski, W & H Rosenthal 1999 Politically Determined Income Inequality and the Provision of Public Goods

 

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