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Private Sector Engagement: What's Economics Got to do With It?

This week, Chief Economist Dr. Louise Fox, and Susan Wilder, Policy Advisor on finance and private sector development, celebrate the launch of the Agency’s new Private Sector Engagement Policy with a blog on why economic analysis is critical for effective implementation.

The release this month of USAID’s Private Sector Engagement (PSE) Policy marks an important milestone in USAID’s transformation to a 21st century aid agency — one that supports a country’s journey to self-reliance. Quoting from the Administrator’s introductory message:

“Private sector engagement is fundamental to our goal to end the need for foreign assistance. This policy is a call to action for USAID staff and our partners to embrace market-based approaches as a more sustainable way to support countries and communities in achieving development and humanitarian outcomes at scale. This is based on our premise that private enterprise is one of the most powerful forces for lifting lives, strengthening communities, and accelerating countries to self-reliance.”

While most of the policy development team has a typical private sector background – finance, corporate strategy and management, etc. – economists have played a significant role. We argue that economists’ role should expand during implementation.

Market-based approaches only deliver improvements in economic welfare if the market works efficiently. The key concept here is competition. Firms compete to sell products to their customers, ensuring a low price, right? But that might not happen for several reasons.

Public sector suppliers in the market create barriers to entry. For example, many governments worry that milled grain, a staple food for the poorest consumers, might not be available. So the government builds a grain mill. The private sector does not enter this market after that because they expect that the government will protect its own investment from private sector competition, so they will not be able to make a profit. This often happens in supply chains for publicly-provided services, such a manufacture of medical or educational supplies.

Lack of information, for example about the behavior and track record of potential borrowers, discourages banks from lending to small and medium enterprises (SME) or enterprises run by women or other excluded groups (who may be incorrectly perceived as higher risk borrowers). Lack of knowledge about new technology and its potential, information that may be costly to acquire and use, can operate in the same way.

Positive externalities can cause coordination problems. Consumers lack information about the health benefits of solar power or high quality medications. The first firm to enter the market will have to spend a lot of resources on finding the key price points and marketing products to consumers. But once they have done that, competitors will enter, benefitting from all the initial firms’ hard work. So a product with major benefits to society will not be available.

Negative externalities, for example, pollution also need to be concerned. If other firms in the market are causing negative effects of production such as pollution, the non-polluters will pull out as they can’t make a profit. A regulation may be needed, or enforcement may need to be strengthened.

The answer to these problems is clear – make the market work better so the private sector can create value, spurring economic growth, jobs, and a lower cost of living. But there is a danger. What if, by engaging with a private sector partner, USAID ends up inadvertently reducing competition, rather than increasing it? We would end up with a sustainable solution, but not one that makes the biggest contribution to improved welfare.

It is not enough to just do a descriptive analysis of where the private sector is and is not. While designing a program involving the private sector, the new USAID PSE Policy calls for Agency staff and our partners to analyze the potential of market-based solutions, and how they can be maximized.

Who has the tools to do this analysis? Economists, of course. The tools of economic analysis can help answer questions about the structure of markets and the role of public and private actors. We can analyze the economics of a given value chain. We can identify where competition should have emerged and did not, including by benchmarking the market where we are working with other countries to see if prices are lower and more firms are entering. We can figure out if the problem is on the supply side (a coordination problem or barriers to entry) or on the demand side (information for consumers, for example). If a subsidy is needed to kick start a market, we can determine where it would be less market-distorting and more sustainable – the demand side, or the supply side. We can identify models of regulation that have produced an acceptable quality at a low cost. We can collect data to evaluate risk, and see if it is being priced appropriately in the market (and make sure we do not over-subsidize risk-taking either). We can suggest methods of doing our work which crowd in the private sector, rather than exclude it.

If USAID is to be successful in adapting its ways of doing business to crowd in and develop the private sector in our partner countries, we will need all the skills of the Agency and our implementing partners. The Chief Economist and the Bureaus of Policy, Planning and Learning and Economic Growth, Education, and the Environment are trying to make sure the economists are ready to assume our role on the team.

For a quick primer, see this recently produced guide by the Donor Committee for Enterprise Development on Minimizing the Risk of Negative Market Distortions in Private Sector Engagement.