Felix Rippy V-663

Policy Issue Paper 1 Market Failure

To: Professor Cali Curley, CEO, Summer SPEA Internship, Inc.
From: Felix Rippy
Date: February 9, 2017
Re: Market (and Government) and Government Intervention The Case
of American Public and Private Prisons

Executive Summary

An instructive example of market failure is the (currently retreating) privatization of the American

prison system. Interestingly, the 1980s boom in these private prisons was itself a response to a classic

example of (perceived) government failure in the provision of this public safety function. This memo

examines neither the initial creation of the public prison system by the government as a response to a

Constitutionally mandated non-economic measure of social welfare, nor the countervailing initial expansion

of the private prison system from the mid-1980s through 2012 as a response to a perceived government

failure in the administration of this original public prison system. Rather, this study examines the market

failures responsible for the ongoing public reclamation of privatized prisons. The ultimate solution offered

herein is not merely for the government to require that all prisons be publicly run, but also drastically to

reduce prison populations as a whole.

Background

At the time of the 1980s prison privatization movements beginnings, the government was criticized as

ineptly managing incarceration of criminals in a manner that reduced overall welfare of society. In short, the

trend toward privatization of prisons began in earnest in the mid1980s, as public prison costs soared and

unconstitutional overcrowding ensued (Findlaw, 2013 and Pauly, 2016). The impulse to privatize prisons

thus related not only to a 1980s shibboleth that private industry was simply more efficient than government,

but private prison growth also related to the unconstitutional levels of prison overcrowding related to the

newly minted war on drugs (Findlaw, 2013 and Pauly, 2016). Hence the 1983 formation of Correction

Page - 1 - of 9
 Corporation of America and, soon after, the 1987 formation of Wackenhut Corrections Corporation, which

in turn gave birth to privatization of the American prison system (Findlaw, 2013 and Pauly, 2016). Now,

after over 30 years of experience with private prisons, and these two companies, the government has

increasingly recognized them as a (market) failure, which begs the question of what interventions the

government should make to address this failure.

A Fifth Type of Market Failure as It Applies to Private Prisons

The 1980s devotion to privatization has its roots in sound economic policy, as ideally, albeit

theoretically, a competitive private market produces, with no need for any public policy or governmental

interference, a Pareto-efficient allocation of goods and services. In this allocation, no one person could be

made worse off without making someone else better off. However, this privatization movement specifically

ignored the fact that it is universally accepted economics that decentralized, private individual (non-

governmental) behavior often simply does not lead to Pareto efficiency (Weimar, 2011).

The four most common market failures (where private behavior produces inefficiency) involve instances of

public goods, externalities, natural monopolies, and information asymmetries (Weimar, 2011, p. 71). Every

one of these four applies to private prisons. But, prior to discussing how these textbook market failures apply

to private prisons, to these four primary market failures is added a fifth. As mentioned above, there are some

industries that by law, must, regardless of efficiency, be performed at least in part by the government to protect

equitable and Constitutional interests. The Court system (and at least partially the prison system) is such an

industry. The United States Federal Constitution, at Article III, creates the Courts and gives them the exclusive

power over Trial of all Crimes (U.S. Const. art. II, 2), as well as requiring unanimous jury verdicts for

criminal conviction,1 although private trials and simple majority verdicts might well be more efficient.

Similarly, the Sixth Amendment provides for a right to a (free) lawyer, despite inefficiencies implied thereby.

(U.S. Const. amend. VI). Although the Constitution does not, however, require that prisons be owned or

1
Andres v. United States, 333 US. 740, 748 (1948). "In criminal cases this requirement of unanimity extends to all issues ...which are left to the
jury."

Page - 2 - of 9
operated by the government, it does indeed apply to the behavior toward inmates by private prisons (Volokh,

2014), as private prisons tout as one of their salutary checks and balances the fact that they can be sued for tort

like a private company, as well as being policed for constitutional violations (Volokh, 2014). So, many federal

and state prisons thus became privatized, to the extent that virtually all new U.S. prisons opened from 2000-

2005 were private, and private prisons housed 8% of U.S. inmates by 2008, including more than 16% of

federal prisoners (Kirchhoff, 2010). Thus, what is described above is a fifth common type of market failure,

which can be described as private prisons failure to recognize that in their industry the Constitution demands

inefficiency to promote social welfare. Private prisons emphasis on efficiency is actually a market failure.

Private prisons cost-cutting resulted in riots and escapes (Camp, 2002). Prisons are not supposed to be merely

efficient; they are ordered to be Constitutional. As discussed below, private prisons turn out to be neither.

Application of the Four Traditional Market Failures to Private Prisons

There remain four traditional market failures, each of which apply to private prisons, and each of which

should have put policy-makers on notice that privatization of prisons would create market failure. The first

classic situation where market failure occurs is where a good is a pure public good, or collective good

(Weimar, 2011, p. 72), which means that the public good must be (at least over some range of consumption)

nonrivalrous and nonexcludable. The application of this principle of market failure to prisons is not at first

obvious, as prisons by definition allow limited access and are rivalrous, in the sense that Constitutional

limits on overcrowding prevent congestion beyond certain parameters. But, prisons do not provide a room

with a market price, but rather provide the nebulous concept of public safety, which in turn is a classic

example of a public good, in that public safety is both non-rival and non-excludable. That is, there is simply

no way to prevent all members of a community from benefiting from the social order that results from

punishing criminal behavior, and, further, intake of a lower crime rate by one person fails to lessen its

obtainability for others. Thus, even though prisons may at first appear to be the ultimate in excludability,

there will always be free riders; for example, those who may not pay taxes in a given area.

Page - 3 - of 9
 Put another way, where a good is rivalrous, the marginal cost of a good is equal to its marginal benefit

(Weimar, 2011, p. 73). But as discussed above, public order is nonrivalrous, and research indicates that the

marginal benefits from incarceration depend entirely on the percentage of citizens incarcerated in the first

place (Liedka, et al., 2006). At some point, in fact, incarcerating more citizens actually has a negative

marginal benefit to society (Liedka, et al., 2006, and Ludwig, 2010). In sum, any good that is not purely

private is considered to be a public good, (Weimar, 2011, p.72) and prisons provide a pure public good that

should have been predicted ex ante to result in market failure when provided instead by the private sector.

Externalities, natural monopolies, and information asymmetry are the remaining three market failure

conditions applicable to private prisons that should have put government policy makers on notice that

privatization of prisons would require government intervention.

Externalities occur when the social costs or benefits of an act (incarceration) cannot be linked to the

private costs of the act (Weimar, 2011). There simply is no accurate means of linking the cost of

incarcerating a person with the benefit (or cost) to society. This externality effect is demonstrated by the

fact that, above a certain level, further incarceration actually apparently has a negative marginal benefit to

society, while the owners of private prisons continue to benefit from such mass incarceration because they

are paid on a per prisoner basis. (Liedka, et al., 2006, and Ludwig, 2010). The negative externality involved

in privatization of prisons is that of forcing the cost of mass incarceration onto society without the private

prison corporation incurring any of the costs, and in fact privately continuing to benefit. This disconnect

between public and private costs is classic externality and market failure requiring government intervention.

Similarly, private prisons are a natural monopoly in that once the sunk costs of building a prison are

incurred, such high initial fixed costs mean that average costs of incarceration decrease as demand

increases, and effectively deter any other entrants into the market. Government itself creates a de facto

monopoly with each prison contract as there is only one selected winner of the bidding for governmental

prison contracts per jurisdiction (Fulcher 2012), and the result is that there are only two major corporate

Page - 4 - of 9
players in the private prison market (Findlaw, 2013 and Pauly, 2016) and only one monopsonist buyer,

which is the government. Because of this natural monopoly, private prisons have no incentive to operate at

the lowest possible cost, and the resulting x-inefficiency means that private prison executives far outearn

public sector counterparts. Within these two major players in the private prison industry, executive pay

(paid by the taxpayers) for the CEO of Geo Group and the Corrections Corporation of America (CCA) was

$3.5 million and $3.2 million dollars respectively in 2010 (Simmons, 2013), while a full 6 years later, the

highest paid State of Indiana employee in the Department of Corrections made only $234,000 (Indiana

Transparency Portal, In.gov. Retrieved from http://www.in.gov/itp/2406.htm). With salaries at the top that

are 13 times higher than in the public sector, it is clear that the private prison system is not operating at X-

efficiency, i.e. the lowest costs feasible, a requirement of a non-monopolistic, competitive industry

(Weimar, 2011, p. 102). Instead, private prisons are natural monopolies requiring government intervention.

Finally, information asymmetry is endemic in the private prison system. The private prison

system (the seller) generates externalities toward society (the buyer) that society in turn has difficulty

quantifying. The classification of goods into categories of search goods, experience goods, and post

experience goods is used to reveal cases where an information asymmetry type market failure will

occur (Weimar, 2011, p. 105), and because the long-term effects of imprisonment on society are not

readily apparent and available to be inspected, the consumers of mass incarceration and private prison

contracts (the public and its policymakers) by definition lack information at any meaningful time

regarding the wisdom of private prison contracting and of the resulting incentives for mass

incarceration. The long term effects mass incarceration are only now being understood and even

studied, but seem to include at least the following: the United States incarcerates its citizens at a higher

rate than any nation in the world, while these high incarceration rates seem to bear no correlation to the

crime rate (Hartney, 2006). United States incarceration rates have increased 300% from 1980 to 2004 and at

least one studys conclusion is that the official poverty rate would have fallen considerably during the 1980-

2004 period had it not been for mass incarceration (DeFina, 2009). Moreover, a meta-survey of over two

dozen studies found no advantage to private prisons over public prisons as far as cost effectiveness

Page - 5 - of 9
 (Pratt, 1999). Because they are paid by the prisoner, private prisons simply have a motive to lobby for

unjust and unconstitutional levels of mass incarceration (Marguiles, 2016), whose deleterious effects

are hard to see without later study. In short, there is an information asymmetry because these effects of

the incentives relating to private prisons are only visible ex post facto and long term. Again, government

intervention is necessary due to this informational market failure.

How Has Government Intervened into Private Prisons Market Failure?

It should not have surprised policy makers that introducing the profit motive into the criminal justice

equation gave private prisons many perverse incentives that countervailed Constitutional norms and even

efficiency concerns. One means of reducing the effects of this counter-productive motivation has recently

been simply to shrink the size of prisons -- both public and private. Prison populations have (finally)

leveled off and even begun to decline, as Figure 1, below, demonstrates.

Figure 1: Source, Lofstrom, M., & Raphael, S. (2016).

Page - 6 - of 9
 From an efficiency standpoint, a 2011 event in California is instructive. Courts ordered 17% of the prison

population in California to be discharged within one year (Sundt, 2016). No substantial increase in crime resulted

from this large prisoner discharge. There was, however, a concurrent savings of state money of $453 million dollars

statewide (Sundt, 2016). So, one historic intervention of government, which addresses public and private prisons,

and the mass incarceration on which private prions feed, is simply to begin, for the first time in a generation, the

shrinking of all prisons.

In the federal system, another monumental governmental reaction to the private prison market failure has been

to begin phasing out private prisons, and once again utilizing public facilities whose motivations are more social

welfare oriented and less profit motivated (Zapotosky, 2016). Other commentators have called for the states to

follow suit and thus for governments at any level to enter no more private contracts and to refuse to renew those

currently in force (Fulcher, 2012).

Both solutions are likely necessary, because even in the publicly run prison system, it has been noted that

local prosecutors and judges overuse state prison systems. The state prison system thus operates like a

commons or common-pool resource, where local jurisdictions can freely sentence offenders to state-funded

prisons thereby gaining the benefit of incapacitation at no direct cost to themselves. The consequences of

giving this open access to the prison commons is a tragic overuse of that resource. (Jonson et al., 2015). The

solution is to take not only the action that the Federal Government has taken against private prisons, but also to

take the actions that California took in its state prisons by simply releasing 17% of their non-violent, non-

sexual inmates. Happily, this move toward government ownership of prisons, combined with shrinking the

size of prison populations overall, allows an unusual coexistence of greater efficiency with Constitutionality.

The continued intervention should be that prisons return to being wholly owned by the government (as they

were for centuries) for both efficiency and for Constitutionality, and fewer people should be incarcerated

overall, resulting in BOTH lower crime and tremendous savings.

Page - 7 - of 9
References

Andres v. United States, 333 US. 740, 748 (1948).

Camp, S., & Gaes, G. (2002). Growth and Quality of U.S. Private Prisons: Evidence from National Survey. Criminology
Public Policy 1(3), 427-450. Retrieved from
http://heinonline.org/HOL/Page?handle=hein.journals/crpp1&div=37&g_sent=1&collection=journals#

DeFina, R., & Hannon, L. (2009). The impact of mass incarceration on poverty. Crime & Delinquency. Retrieved from
http://cad.sagepub.com/content/early/2009/02/12/0011128708328864.abstract

Fulcher, P. (2012). Hustle and Flow: Prison Privatization Fueling the Prison Industrial Complex, 51 WASHBURN L.J. 589,
614. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2097864

Hartney, C. (2006). US Rates of Incarceration: A Global Perspective. Retrieved from

http://www.shockedandpersuaded.com/wp-content/uploads/2009/06/2006nov_factsheet_incarceration.pdf

Indiana Transparency Portal. State Employees. Corrections. In.gov. Retrieved from http://www.in.gov/itp/2406.htm

Kirchhoff, S. M. (2010). Economic impacts of prison growth. DIANE Publishing. Retrieved from
https://books.google.com/books?hl=en&lr=&id=HWs_XS7yLEgC&oi=fnd&pg=PA1&dq=Kirchhoff,+S.+M.+(2010)
.+Economic+impacts+of+prison+growth&ots=FaYsAKZo38&sig=9jkv_GmRQ8-
yGe5oLygJIDhw7gI#v=onepage&q=Kirchhoff%2C%20S.%20M.%20(2010).%20Economic%20impacts%20of%20p
rison%20growth&f=false

Liedka, R. V., Piehl, A. M., & Useem, B. (2006). The crime control effect of incarceration: Does scale matter?.
Criminology & Public Policy, 5(2), 245-276. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1745-
9133.2006.00376.x/abstract

Lofstrom, M., & Raphael, S. (2016). Crime, the Criminal Justice System, and Socioeconomic Inequality. The Journal
of Economic Perspectives, 30.2, 103-126. Retrieved from
http://www.ingentaconnect.com/contentone/aea/jep/2016/00000030/00000002/art00005

Ludwig, J. (2010). The costs of crime. Criminology & Public Policy, 9(2), 307-311. Retrieved from
http://onlinelibrary.wiley.com/doi/10.1111/j.1745-9133.2010.00628.x/abstract

Margulies, J. (2016, August 24). This Is the Real Reason Private Prisons Should Be Outlawed. Time Magazine,
Ideas. Retrieved from http://time.com/4461791/private-prisons-department-of-justice/

Pauly, M. (July/August 2016). A Brief History of America's Private Prison Industry. Mother Jones. Retrieved January 31,
2017 from the World Wide Web: http://www.motherjones.com/politics/2016/06/history-of-americas-private-prison-industry-
timeline

Pratt, T. C., & Maahs, J. (1999). Are private prisons more cost-effective than public prisons? A meta-analysis of evaluation
research studies. Crime & Delinquency, 45(3), 358-371. Retrieved from
http://cad.sagepub.com/content/45/3/358.full.pdf+html

Private Jails in the United States (2013). Findlaw. Retrieved January 31, 2017 from the World Wide Web:
http://civilrights.findlaw.com/other-constitutional-rights/private-jails-in-the-united-states.html

Page - 8 - of 9
Schiraldi, V., & Greene, J. (2002). Reducing correctional costs in an era of tightening budgets and shifting public opinion.
Federal Sentencing Reporter, 14(6), 332-336. Retrieved from
http://www.jstor.org/stable/10.1525/fsr.2002.14.6.332?seq=1#page_scan_tab_contents

Simmons, M. (2013, August 7th) Criminal Justice [Web Log Post]. Oklahoma Policy Institute. Retrieved from
http://okpolicy.org/punishment-profits-a-cost-benefit-analysis-of-private-prisons/

Sundt, J., Salisbury, E.J., & Harmon, M.G. (2016). Is Downsizing Prisons Dangerous? The Effect of Californias
Realignment Act on Public Safety. Criminology and Public Policy, 15.2: 315-341. Retrieved from
https://scholar.google.com/scholar?hl=en&q=downsizing+prisons+dangerous+sundt&btnG=&as_sdt=1%2C15&as_sdtp=

U.S. Const. art. II, 2

U.S. Department of Labor, Bureau of Labor Statistics. "Correctional Officers and Jailers." 2000 National OES Estimates,
2000. Retrieved January 31, 2015 from https://www.bls.gov/oes/tables.htm

U.S. Department of Labor, Bureau of Labor Statistics. "Correctional Officers and Jailers." Occupational Employment
Statistics, May 2012. Retrieved January 31, 2015 from https://www.bls.gov/oes/2012/may/oes333012.htm

U.S. Department of Labor, Bureau of Labor Statistics. "Correctional Officers and Jailers." Occupational Employment
Statistics, May 2015. Retrieved January 31, 2015 from https://www.bls.gov/Oes/current/oes333012.htm

Volokh, A. (1997). N guilty men. University of Pennsylvania Law Review, 146(1), 173-216. Retrieved from
http://www.jstor.org/stable/3312707?seq=1#page_scan_tab_contents

Volokh, S. (2014, February 17) The Supreme Court has restricted civil rights litigation by federal private prison inmates:
should we care? Washington Post, https://www.washingtonpost.com/news/volokh-conspiracy/wp/2014/02/17/the-supreme-
court-has-restricted-civil-rights-litigation-by-federal-private-prison-inmates-should-we-care/?utm_term=.ebe2f267e087

Weimer, D. L., & Vining, A. R. (2015). Policy analysis: Concepts and practice. Routledge.

Zapotosky, M., & Harlan, C. (2016, August 18). Justice Department says it will end use of private prisons, The Washington
Post, https://www.washingtonpost.com/news/post-nation/wp/2016/08/18/justice-department-says-it-will-end-use-of-private-
prisons/?utm_term=.6482a677be8c.

Page - 9 - of 9