The Effects of Institutional Arrangements in Local Water Supply Services in Korea

Suho Bae, Ph.D. Graduate School of Governance Sungkyunkwan University, Seoul, Republic of Korea [email protected]

Moon-gi Jeong, Ph.D. Graduate School of Governance Sungkyunkwan University, Seoul, Republic of Korea [email protected]

Seong-gin Moon, Ph.D. Department of Public Administration Inha University, Incheon, Republic of Korea [email protected]

ABSTRACT

In Korea, local governments are mainly responsible for providing water supply services to citizens. Since 2004, 15 local governments have contracted this service to Korean Water Resources Corporation (K-Water). This paper examines the effects of the two different institutional arrangements— direct public delivery versus contracting out to K-Water—on cost saving and productivity. To do so, it employs a hybrid cost function approach and uses panel data covering the nine years from 2000 to 2008 in local governments. Empirical findings show mixed evidence on the effects of the two institutional arrangements on cost savings and productivity gains. Water supply costs are significantly lower under contracting out than under direct public delivery. But local water supply systems achieve productivity gains in both institutions, and there are no significant differences in productivity gains between them. Local water supply systems need to further reduce average water supply costs through increasing their size and magnitude.

Keywords: water supply services; contracting out; total factor productivity (TFP); economies of scale; factor substitutability.

Presented at the Annual Conference of the Association for Public Policy Analysis and Management, May 25-27, 2013 in Shanghai, China.

I. Introduction

Local service delivery mode and its efficiency have gained continuing attention among scholars and practitioners over several decades. The monopolistic public service delivery by governments has been criticized as inefficient. Thus, as an alternative institutional arrangement, private production including contracting out has been supported to reduce costs and improve productivity. While this line of research was largely conducted in the context of western countries, alternative service delivery mode is also gaining significance in the countries with transitional economies, including South Korea. In particular, water supply services, which are one of crucial services for quality of life at the local level, face challenges from citizens for better quality of water services with lower costs. One of solutions to resolve such challenges is to employ an alternative service arrangement through privatization (or contracting out).

In Korea, local governments are mainly responsible for providing water supply and wastewater treatment services to citizens. Since 2004, instead of direct delivery of water supply services, some local governments have slowly adopted another type of institutional arrangement, that is, contracting out to Korean Water Resources Corporation (K-Water), in operating and managing water supply systems and delivering water supply services to their residents.1 Currently, 15 water supply systems among 164 local systems deliver water supply services to their residents under contracting out to K-Water.

This paper examines the effects of the two different institutional arrangements – direct public water delivery service versus contracting out to K-Water – on cost saving, productivity, economies of scale, and factor substitutability in delivery of local water supply services in Korea. This study advances the previous research on contracting out and cost

2 savings in water supply services using the Korean case. First, most previous studies primarily focused on U.S. and U.K. data for empirical analysis. Only a few studies examined developing countries including Asian and Pacific countries as well as African countries (e.g.,

Estache and Rossi, 2002; Jones and Mygind, 2000; Kirkpatrick, Parker, and Zhang, 2006).

For example, Estache and Rossi (2002) examined 50 water supply systems in Asian and

Pacific countries, and Kirkpatrick et al. (2006) examined 76 water supply systems in African countries. But these cross-country studies could not control for unexplained variations across countries such as water- and sewer-related regulatory frameworks, natural environments, and geographical characteristics. This paper uses data from water supply systems in South Korea, which will help improve the efficiency of empirical estimation and provide a more precise estimate of the effects of public delivery versus contracting out on cost savings and productivity. Second, in empirical estimation, it employs explanatory variables representing service attributes and local characteristics related to water supply services, such as pipe length, water supply capacity, water supply rates, recovery rates of water supply costs from water charges, and population density. This approach also helps improve the efficiency of empirical estimation and provides a more precise estimate of the effects of public delivery versus contracting out for water supply services. Third, it examines differences in productivity between the two institutional arrangements. For a more sophisticated model to explain the relationship between contracting out and cost saving in water supply services, this study employs a hybrid cost function approach to measure total factor productivity (TFP), supply elasticity of cost, return to scale, price elasticity of input demand, and the Morishima elasticity of substitution. For empirical estimation, it uses cross-sectional time-series data covering the nine years from 2000 to 2008 in Korean local governments.

In Section II, this paper explains the local water supply systems in Korea and provides an overview of the current literature on privatization and contracting out in provision and delivery of water supply services. Then, Section III presents an empirical model for parameter estimation, along with TFP, supply elasticity of cost, return to scale, price elasticity of input demand, and the Morishima elasticity of substitution. Section IV describes data sources and variables, along with descriptive statistics. Section V presents empirical findings, and Section VI summarizes empirical findings and discusses study limitations.

II. Literature Review

1. Privatization of Water Supply Services

According to Vickers and Yarrow (1991), privatization can be classified into three types. The first type is “privatization of competitive firms,” which means transferring “state- owned enterprises operating in competitive product markets” to the private sector. The second type is “privatization of monopolies,” which means transferring “state-owned enterprises with substantial market power” to the private sector. The third type is contracting out of public services that were previously financed and delivered by the public sector. In most cases, privatization of water supply services can be categorized as the third type of privatization. Pure privatization means transferring the ownership of physical assets from the public sector to the private sector, while contracting out means that private companies only operate and manage water supply systems while the public sector still maintains the ownership of physical assets (Domberger and Jensen, 1997). According to Vickers and

Yarrow (1991), however, since contracting out allows private companies to take profits and financial surplus from service delivery, the transfer of profits to private companies can be 4 also considered as a kind of privatization. Thus, contracting out is not different from privatization.

Since the mid-1970s, empirical studies have examined the relationship between privatization or contracting out and cost savings in water supply services. Most previous studies have examined privatization in U.S. and U.K. contexts and provided mixed empirical findings (Bel and Warner, 2008). Some studies have found that costs of water supply services are significantly lower under direct public delivery than under private delivery (e.g.,

Bhattacharyya, Parker, and Raffie, 1994; Bruggink, 1982; Lynk, 1993; Mann and Mikesell,

1976; Souza, Faria, and Moreira, 2008), while others have suggested the opposite effect (e.g.,

Crain and Zardkoohi, 1978; Morgan, 1977; Raffie et al., 1993) or have found no significant difference between the two institutional arrangements with respect to cost savings (e.g.,

Ashton, 2001a, 2001b; Brynes, 1991; Feigenbaum and Teeples, 1983; Fox and Hofler, 1986;

Teeples and Glyer, 1987; Bhattacharyya et al., 19952; Saal and Parker, 2000).

While an alternative service delivery mode such as contracting out gained great significance for efficient delivery of public services, most findings are at best mixed. This paper attempts to examine the Korean experience of an alternative institutional arrangement for water supply services. Korea, which has a rapidly changing economy, has tried to provide innovative public service delivery systems through privatization or contracting out. This examination of a transitional economy expands the current literature regarding the monopolistic delivery of public services by governments and an alternative service delivery system.

2. Local Water Supply System in Korea

Local governments in Korea are mainly responsible for the provision of water supply services. A majority of local governments directly produce and deliver this crucial service to their residents. It is known that water supply systems in small rural local governments are operated and managed inefficiently. Inefficient operation and management have been controversial policy issues in Korea. For instance, in 2008, water supply costs were 2,703

Korean won (KRW) per m³ in Imsil and 2,402 KRW per m³ in Yeongwol, while 414 KRW per m³ in Gumi and 448 KRWs per m³ in Seongnam. In addition, small local water supply systems have very low levels of water supply rates, which are measured as the number of served residents by a water supply system as a share of the number of total residents. For instance, in the same year, 26 small local water supply systems among 164 local water supply systems had lower than a 50% water supply rate. In addition, 59 small water supply systems had between 50% and 80% water supply rates (Korean Ministry of Environment, 2009).

To address such inefficient operation and management of water delivery service by small local governments, the Korean central government has launched a middle- and long- term master plan for integrating the local water supply systems. The plan has called for the dramatic restructuring of local water supply systems in two aspects (Korean Ministry of

Environment, 2010). First, small-scale water supply systems will be integrated into large- scale water supply systems in order to (1) realize efficiency, productivity, and economies of scale; (2) reduce regional gaps in water prices and water supply rates across water supply systems; and (3) improve the quality of water supply services. Accordingly, 164 local water supply systems are being consolidated into 39 systems by 2020 and 5 systems by 2030. For example, as a part of this effort, the four small water supply systems in Sacheon, Geoje,

Tongyeong, and Goseong were consolidated into one water supply system in 2009, which was contracted out to K-Water for its operation and management.

Second, after creating large-scale water supply systems, the Korean government plans to encourage local governments to adopt other institutional arrangements of water service delivery other than direct water delivery by local governments, including contracting out to public enterprises such as K-Water and Korean Environmental Corporation,3 creating new local water corporations, creating water supply partnerships among local governments, and providing direct delivery by provincial government. According to survey results, most local governments prefer contracting out to public enterprises to the other aforementioned three institutional arrangements of water service delivery in newly consolidated water supply systems (Korean Ministry of Environment, 2010). Since 2004, local governments have been able to choose whether they directly deliver water supply services to their residents or outsource this crucial public service to K-Water.

Since its establishment in 1967, K-Water has played significant roles in water resources policy and management in Korea, including constructing and managing multi- purpose dams and operating and managing regional water supply systems (website of K-

Water). As of March 2009, K-Water managed 15 local water systems and delivered water supply services to their residents.4 Table 1 presents water supply capacity, water supply rates, and contract period in these 15 water supply systems operated and managed under contract with K-Water.

[Table 1] about here

III. Empirical Model of Water Supply Services

Many previous studies utilize a hedonic cost function approach to analyze costs and efficiency of local water supply services (e.g., Feigenbaum and Teeples, 1983; Schmit and

Boisvert, 1996).5 Under the framework of a hedonic cost function, the production function for water supply services in local jurisdiction i in year t can be written as:

Qit  F(Yit ; Jit,1, Jit,2, Jit,3,...... , Jit,m )  F(Lit , Kit ) [1]

where Qit () is an index of water output in local jurisdiction i in year t and Yit represents the total amounts of water supply services that local jurisdiction i delivers to its residents in year t. Jit,1, Jit,2 , Jit,3,...... , Jit,m represent the factors characterizing institutional and service attributes in local jurisdiction i in year t related to the total amounts of water supply services

produced and delivered to its residents (Yit ). Thus, output of water supply services in local

jurisdiction i in year t (presented asQit ) reflects annual production and treatment of raw water

and annual delivery of treated water (measured in tons per year and presented as Yit ), as well

as associated institutional and service characteristics ( Jit,1, Jit,2 , Jit,3 ,...... , Jit,m ).

Lit represents employees working for the production, treatment, and delivery of water supply

services in local jurisdiction i in year t, and Kit represents private capital stock employed for water production, treatment, and delivery in local jurisdiction i in year t.

Based on duality theory, we can derive an indirect cost function from the production function, as shown in equation [1], as follows:

TC  TC (Q (Y ; J , J J ,...... , J );P , P ; H , H , H ,...... , H ) [2] it it it it it,1 it,2, it,3 it,m it,L it,K it,1 it,2 it,3 it,n

where total costs of water supply services in local jurisdiction i in year t (TCit) are a function of exogenously determined input prices (Pit,L, Pit,K), output (Qit), and fixed factors (Hit,1, Hit,2, Hit,3,

……., Hit,n). Pit,L and Pit,K are wage per employee and user cost of private capital per unit in the production, treatment, and delivery of water supply services in local jurisdiction i in year t, respectively. 8

In order to estimate the effects of different institutional arrangements on costs of water supply services using the case of Korean local governments, we utilize a hybrid translog cost function. This function is constructed through the second-order Taylor expansion series, thus allowing for interaction terms and quadratic functional forms among explanatory variables (Bae, 2009, 2010; Caves, Christensen, and Tretheway, 1980; Simon and Blume, 1997). In short, it has a flexible functional form that can approximate any true differentiable function without requiring restrictive assumptions like separability and accounts for the relationships among the input factors. It also avoids the risk of introducing bias into the estimation as a result of model misspecification. This translog cost function approach has been extensively employed in many previous studies to examine performance of public service provision and delivery (Ashton, 2000a, 2000b; Bae, 2009, 2010; Bhattacharyya, Parker, and

Raffie, 1994; Bhattacharyya et al., 1995; Bruggink, 1982; Feigenbaum and Teeples, 1983;

Lynk, 1993; Saal and Parker, 2000; Schmit and Boisvert, 1996; Teeples and Glyer, 1987).

From equation [2], the following translog cost function is used for empirical estimation:

1 2 1 2 1 2 lnTCit =α0 + αy(lnYit) + /2αyy(lnYit) + βl(lnPit,L) + /2 βll(lnPit,L) + βk(lnPit,K) + /2 βkk(lnPit,K)

+ αyl(lnYit) (lnPit,L) + αyk(lnYit) (lnPit,K) + βlk(lnPit,L) (lnPit,K) + Σβm (lnJit,m) + Σ βn (Hit,n)

+ βt (YEARt) + βs (PROVINCEs) + it [3] where yearly and province dummies are employed to control technical advances and unexplained variations across years and provinces in Korea. It is assumed that lnQit = lnYit +

lng(Jit,1, Jit,2, Jit,3, ………., Jit,m) and lng(.) = Σρl (lnJit,m) (Feigenbaum and Teeples, 1983; Schmit and Boisvert, 1996).

In equation [3], the symmetry requirement implies ij   ji for i  j , and the following conditions are also required to satisfy the homogeneity of degree one:

 i  1;

ij  0 ;

and  yi  0 for i, j  L or K . [4]

Utilizing Shephard’s lemma, two demand functions in the shares of water supply costs can be derived from the translog cost function in equation [3]. Because the cost shares sum to unity, however, the covariance matrix is singular. In other words, any of the share equations can be expressed as a linear combination of the other share equation. For the purpose of avoiding the problem of singularity, one share equation needs to be deleted in empirical estimation (in this paper, the share equation of private capital). The share equation of labor in local jurisdiction i in year t, via Shephard’s lemma, is derived from the function in equation [3], as follows:

 lnTCit Sit,L  ( )  l  ll ln Pit,L   yl lnYit  lk ln Pit,K [5]  ln Pit,L

The translog cost function in equation [3] and the share equation of labor in equation

[5] are estimated as a system, using Zellner’s seemingly unrelated regression (SUR) method

(Greene, 2011; Zellner, 1962). This estimation method produces the same empirical results as the equation-by-equation ordinary least squares (OLS) method (Cameron and Trivedi, 2005, pp. 209-210). In empirical estimation, slope coefficients are restricted to be identical to each other across the two equations (Cameron and Trivedi, 2005, p. 210). For example, αyl in equation [3] should be the same as αyl in equation [5].

1. Total factor productivity and efficiency gains

The translog cost function, presented in equation [3], is estimated along with the labor cost share equation, presented in equation [5], to compare TFP levels between the two institutional arrangements, direct public delivery versus contracting out to K-Water. The average TFP level is measured by the average value of all residuals from the estimated translog cost function. Here, the residual of an observation measures the logarithmic deviation of the observation’s TFP level from the average productivity of all samples (Bae,

2009, 2010; Lichtenberg and Siegel, 1987; Martin, McHugh, and Johnson, 1991). Thus, the residual represents the relative TFP level, compared with the average TFP level of all samples. Since this paper uses a cost function approach, a smaller value of residual represents better productivity. For the same reason, a negative value of residual represents a relative efficiency and productivity gain, while a positive value represents a relative efficiency and productivity loss.

2. Supply elasticity of cost and economies of scale

To analyze whether local water supply systems have realized economies of scale, this paper looks at return to scale (RTS), which is calculated as the inverse of supply elasticity of cost. The supply elasticity of cost with respect to total amounts of water produced and

delivered to its residents in local jurisdiction i in year t (Yit ) can be derived from the function in equation [3], as follows:

 lnTCit   y   yy lnYit   yl ln Pit,L   yk ln Pit,K [6]  lnYit

From equation [6], return to scale (RTS) in local jurisdiction i in year t can be

1 calculated as: RTS  . RTS it  1 implies that average costs can be further saved it  ln TC it  ln Yit through expanding the size and magnitude of local jurisdiction i’s water supply system.

RTS it  1 implies that it is necessary to reduce the size and magnitude of local jurisdiction i’s

water supply system to save average costs and improve efficiency. RTS it  1 implies constant return to scale and no existence of either economies of scale or diseconomies of scale in local jurisdiction i in year t.

3. Price elasticity of input demand and elasticity of substitution

Own- and cross-price elasticities with respect to an input factor can be written as:

I P  i ii  ii    S i   1 Pi I S i

J P  i ji for i, j = L or K [7]  ji    S i  Pi J S j

where  ii represents percent change in the demand for input i in a response to percent change

in its own price, and  ji represents percent change in the demand for input j in a response to

percent change in input i.  ji  0 implies the substitution relationship between labor and

private capital and  ji  0 implies the complementary relationship between the input factors.

The Morishima elasticity of substitution with respect to an input factor can be presented in terms of own-price and cross-price elasticities, as follows:

 ji   ji ii for i, j = L or K [8]

where the Morishima elasticity of substitution,  ji , measures percent change in the factor ratio of input j to input i when the price of input i increases by 1%, under the assumption that the price of the other input j is held constant (Nguyen and Streitwieser, 1999).  ji  0 implies

12 that labor and private capital are Morishima substitutes and  ji  0 implies that they are Morishima complements.

IV. Data, Variables, and Descriptive Results

1. Data and variables

This paper analyzes what factors and characteristics, particularly focusing on institutional arrangements in the delivery of local water supply services, affect performance of local water supply services in Korea. It utilizes Korean local government data, covering

156 local water supply systems for the nine years from 2000 to 2008.6 All data for empirical estimation were obtained from the Korean Ministry of Environment. All continuous variables measured in KRW are reported in constant 2008 KRW using GDP deflators.

Total costs of water supply services cover all kinds of costs occurred in obtaining and treating raw water and delivering treated water to residents in a year. Total costs are calculated from the summation of labor and capital expenditures. Wages per employee is obtained from labor expenditures divided by the number of employees in a local water supply system. User cost of private capital per unit is calculated from capital expenditures divided by capital stock. Since no data on capital stock are available, however, the ratio of capital outlays to total government expenditures in a local government for each fiscal year is employed as a proxy for user cost of capital, under the assumption that user cost of private capital increases as the local government spends more money on capital outlays in a given year (Bae, 2010). Cost share of labor is obtained from labor expenditures divided by total water supply costs, while cost share of private capital is obtained from the cost share of labor being subtracted from unity. 13

Annual total amounts of water produced, treated, and delivered to residents (presented

as Yit , m³) are employed to represent the demand for local water supply services. Seven variables are also employed to represent institutional and service attributes associated with the production, treatment, and delivery of water supply services, including institutional arrangements of service providers and service characteristics. The first variable is who manages and delivers local water supply services (local government versus K-Water). It is coded as 1 if K-Water manages and delivers water supply services to residents under contracting out, but coded as 0 if local government delivers this service to residents directly.

As already mentioned in Section II, the existing literature shows mixed evidence on the relationship between institutional arrangements and cost savings and productivity gains. Thus, it is uncertain whether service benefits from contracting out to K-Water, expressed in terms of cost savings and productivity gains, are significantly greater than direct service delivery by local government in the treatment, delivery, and management of local water supply services.

Second, a local water supply system’s supply capacity is measured as the amounts of water that the water supply system can produce for one year to the maximum extent. Thus, it is expected that water supply costs increase, along with an increase in the water supply system’s supply capacity. Third, the length of water distribution pipes is also likely to contribute to an increase in water supply costs. Fourth, water supply rates are measured as the number of residents to whom a water supply system delivers water services, as a share of the total number of residents in a local jurisdiction. Thus, all other things being constant, it is expected that water supply rates are positively associated with costs of water supply services.

Fifth, leakage rates are measured as the amounts of water which are leaked through cracked pipes during obtaining and treating raw water and delivering treated water, as a share of the total amounts of water produced and delivered in a water supply system. Thus, leakage 14 rates are employed for empirical estimation to measure to what extent a water supply system is managed and operated efficiently. Thus, all other things being equal, along with an increase in leakage rates, costs of water supply services are likely to increase as well. Sixth, rates of recovering water supply costs from water charges are employed to represent the extent that a local water supply system recovers water supply costs from levying water charges to its residents. Among several demand-side management tools, this is considered as one of the most important policy tools that local governments usually employ to conserve water resources and reduce water consumption (Wang et al., 2006).7 As rates of recovering water supply costs from water charges get close to 100%, residents consume less water, thus contributing to water conservation; that is, recovery rates from water charges are expected to be negatively associated with costs of water supply services. Seventh, population density is measured as the number of residents per km² in a local jurisdiction. All other things being constant, along with an increase in population density, water supply costs are likely to increase as well.

This paper employs eight yearly dummies to control for technological advances in water supply services and unexplained variations. The year 2000 is used as the base year for these yearly dummies. Eight province dummies are introduced for empirical estimation to control for relatively constant characteristics and unexplained variations across provinces in

Korea. Korea comprises nine provinces: Gangwon, Gyeonggi, Gyeongnam, Gyeongbuk,

Jeonnam, Jeonbuk, Jeju, Chungnam, and Chungbuk. In each province, local governments are similar in geographical location, culture and tradition, level of development, and economic/industrial structure. Gyeonggi province is used as the base category for the other eight province dummies.

2. Descriptive results

Table 2 reports descriptive results on the variables employed for empirical estimation.

Costs of water supply services under direct public delivery were smaller than under contracting out to K-Water. On average, local water supply systems under public delivery were relatively labor intensive, while water supply systems under contracting out were relatively capital intensive. Average wages per employee were much higher under contracting out than under public delivery, but the ratio of capital outlays to total government expenditures in a local government, as the proxy variable of user cost of private capital, was not much different between the two institutional arrangements.

[Table 2] about here

Water supply capacity and amounts of water produced and delivered were higher under public delivery than under contracting out. But water supply rates and pipe length were smaller under the former institutional arrangement than under the latter. Leakage rates, representing inefficiency in operation and management of water supply system, were higher under contracting out than under public delivery, while recovery rates of water supply costs from water charges were slightly higher under public delivery than under contracting out.

Population density was higher under public delivery than under contracting out.

V. Empirical Results

1. Parameter estimates and total factor productivity level

Table 3 reports empirical results for water supply services in Korea. To improve efficiency of empirical estimation, the three translog cost functions were estimated, along with their cost share equations of labor, using Zellner’s SUR estimation method. The cost share equation of private capital was omitted to avoid the problem of singularity. As shown in

Table 3, Models 1 and 3 were estimated with eight province dummies and eight yearly dummies, but Model 2 was estimated without them. All the first-order and second-order coefficients of input prices and total amounts of water produced and delivered (except the first-order coefficients of wages per employee in Models 1 and 3 and the first-order coefficient of total amounts of water produced and delivered in Model 1) are significant and have expected signs. Since some coefficients are not statistically significant, however, one needs to be careful in interpreting supply elasticity of cost, return to scale, price elasticity of input demand, and the Morishima substitutability across the input factors. R²’s values for the cost functions are 0.6848 to 0.9519, while R²’s values for the cost share equations of labor are -0.8273 to 0.0617.

[Table 3] about here

Several variables are employed to account for institutional and service attributes associated with water supply services. Water supply capacity and pipe length significantly contribute to an increase in total costs of water supply services. Along with a 10% increase in water supply capacity, water supply costs increased by about 1.2% to 1.9%. A 10% increase in pipe length led to an increase in water supply costs by about 4.4% to 6.7%. As expected, recovery rates from water charges, which are considered as one of the most important demand-side management tools in reducing water consumption and conserving water resources, have negative effects on water supply costs. According to empirical results in

Model 2, three variables (water supply rates, leakage rates, and population density) significantly contribute to an increase in water supply costs.

The main purpose of this paper is to examine cost savings and productivity gains in water service delivery between two institutional arrangements, direct public delivery versus contracting out to K-Water. We accomplished this task in two ways. First, in empirical estimation, we included a dummy variable on institutional arrangement of water service delivery, as shown in Models 2 and 3 of Table 3. Second, we measured relative TFP levels between the two institutions, using parameter estimates in Model 1 of Table 3. According to empirical results in Models 2 and 3, water supply costs were significantly lower under contracting out to K-Water than under direct public delivery. On average, water supply costs were lower by about 1,010 million KRW to 1,411 million KRW under contracting out than under public delivery.

On the other hand, Table 4 reports average value of the residuals obtained from the estimated translog cost function in Model 1 of Table 3, which represents the relative TFP level for each group. Relative TFP level means the relative distance from average productivity of all water supply systems, which was obtained from empirical estimation of

Model 1 of Table 3. Since this paper utilizes a cost function approach, a smaller value of residual means better productivity, and a negative value of residual implies efficiency gains.

[Table 4] about here

According to Table 4, on average, water supply systems achieved efficiency and productivity gains (average residual value was -0.0049). Water supply systems in the two institutional arrangements also achieved efficiency and productivity gains (-0.0026 and -

0.1230 under direct public delivery and under contracting out to K-Water, respectively). A mean-difference test was conducted to examine whether these gains are significantly different 18 between the two institutions. According to test results in Table 4, however, there is no significant difference between them. This finding is not consistent with empirical findings in

Models 2 and 3 of Table 3.

2. Supply elasticities of cost and economies of scale

Table 5 reports supply elasticities of cost and RTS in water supply systems for each group. As previously mentioned, RTS is derived from the inverse of supply elasticity of cost.

Supply elasticities of cost were calculated from equation [6], where parameter estimates were obtained from the estimated translog cost function in Model 1 of Table 3 and sample means of variables from Table 2. According to Table 5, on the basis of all samples, the supply elasticity of cost with respect to total annual amounts of water produced, treated, and

delivered (presented asYit ) is 0.211. In other words, average water supply costs increased by about 2.11%, along with a 10% increase in total amounts of water produced, treated, and delivered, thus suggesting that average costs can be further saved and economies of scale can be realized through increasing the size and magnitude of a water supply system.

[Table 5] about here

We also calculated supply elasticities of cost and RTS in the two institutional arrangements. According to Table 5, the supply elasticities of cost with respect to total amounts of water produced, treated, and delivered are not so different from each other in the both institutional arrangements (0.210 under direct public delivery and 0.221 under contracting out to K-Water).

3. Price elasticities of input demand and the Morishima elasticities of substitution

Table 6 reports price elasticities of input demand and the Morishima elasticities of substitution in water supply systems for each group. Price elasticities of input demand were calculated from equation [7], where parameter estimates were obtained from the estimated translog cost function in Model 1 of Table 3 and sample means of cost shares in Table 2. The

Morishima elasticities of substitution were calculated from equation [8], using information on price elasticities of input demand. As shown in Table 6, it should be noted that since there are two inputs, in absolute values, the own-price elasticity of labor is identical to the cross-price elasticity of labor with respect to capital, and the own-price elasticity of capital is identical to the cross-price elasticity of capital with respect to labor. For the same reason, as shown in

Table 6, the two Morishima elasticities of substitution are identical to each other (Bae, 2010).

All own-price elasticities of input demand are negative, which is theoretically correct.

On the basis of all samples, the own-price elasticities of labor and capital are -0.741 and -

0.218, respectively. In short, along with a 10% increase in wages per employee, the demand for employees decreased by about 7.41%. Along with a 10% increase in user cost of capital, the demand for private capital decreased by about 2.18%.

The own-price elasticity of labour is -0.739 under direct public delivery, while it is -

0.818 under contracting out to K-Water. In short, in responding to the high price of labour, water supply systems under contracting out are likely to use less labour than the counterparts under public delivery. The own-price elasticity of capital is -0.220 under public delivery, while it is -0.115 under contracting out. In short, in responding to the high price of capital, water supply systems under public delivery are likely to use less capital than the counterparts under contracting out. 20

On the basis of all samples, the cross-price elasticity of capital with respect to labour is 0.218, thus implying that a 10% increase in wages per employee resulted in an increase in the demand for capital by about 2.18%. The cross-price elasticity of labour with respect to capital is 0.741, thus implying that a 10% increase in user cost of capital led to an increase in the demand for labour by about 7.41%. These cross-price elasticities are positive but less than unity, implying that labour and private capital are weak substitutes.

The cross-price elasticity of capital with respect to labour is 0.220 under direct public delivery, while it is 0.115 under contracting out to K-Water. In responding to an increase in wages per employee, water supply systems under public delivery are likely to use less capital than under contracting out. The cross-price elasticity of labour with respect to capital is 0.739 under public delivery, while it is 0.818 under contracting out. In responding to an increase in user cost of capital, water supply systems are likely to use less labour under contracting out than under public delivery.

[Table 6] about here

All Morishima elasticities of substitution are positive and close to unity, implying that labour and private capital are Morishima substitutes. On the basis of all samples, the

Morishima elasticity of substitution is 0.958, thus implying that a 10% increase in wages per employee (or user cost of capital) resulted in an increase in the ratio of capital to employees

(or the ratio of employees to capital) by about 9.58%. The Morishima elasticity of substitution is 0.959 under direct public delivery, while it is 0.932 under contracting out to K-

Water. Thus, the Morishima substitutability among labor and private capital is similar between the two institutional arrangements.

VI. Conclusions

There has been a long debate regarding the efficiency and effectiveness of public versus private service delivery. Proponents of private service delivery assert that privatization or contracting out can lower service costs and improve the quality of services by eliminating bureaucratic waste and realizing economies of scale. This western style of institutional change of public service delivery systems was broadly applied in the countries with transitional economies. Focusing on water supply services, which are gaining more significance in both developed and developing countries, this paper examined the effects of contracting out on cost savings and productivity gains in Korea. Local governments in Korea that have a long tradition of the monopolistic provision and production of water services have attempted to contract out this crucial service to Korean Water Resources Corporation (K-

Water). This examination of the Korean experiment of contracting out can advance the existing literature on the efficiency and effectiveness of public vs. private service delivery.

For empirical estimation, it used cross-sectional time-series data covering the nine years from

2000 to 2008 in Korean local governments.

The empirical findings provided mixed evidence on the effects of the two institutional arrangements on cost savings and productivity gains. Water supply costs were significantly lower under contracting out to K-Water than under direct public delivery. But water supply systems achieved productivity gains under both institutions, and there were no significant differences in productivity gains between them. The findings suggest that the dichotomy between public and private delivery does not provide clear-cut solutions regarding the efficiency and effectiveness of service delivery. Such findings seem to be consistent with previous research findings on the mixed evidence of an alternative service delivery arrangement or contracting out. One possible explanation in the countries with transitional

22 economies, such as Korea, may be that local governments, which increasingly face severe competition from external producers, are also cautious in improving productivity. If so, seeking alternative institutional arrangement for public service delivery can help local governments improve their internal operation and management for better service delivery

(Bae, 2010; Hodge, 1998).

Water supply systems under both institutional arrangements need to further reduce average costs of water supply services and realize economies of scale through increasing the size and magnitude of water supply systems. As previously mentioned, the Korean central government has made recently efforts at consolidating small-scale local water supply systems into large-scale systems. The empirical findings of this paper suggest that these efforts help reduce water supply costs, improve efficiency, and realize economies of scale. One interesting finding is that recovery rates of water supply costs from water charges, one of the crucial demand-side management tools, can be employed as a useful policy tool to reduce water consumption and save water resources in the future. As shown in Table 2, average recovery rates were about 73% for local water supply systems in Korea. Thus, Korean local governments need to make greater efforts in raising water charges and improving recovery rates.

This paper has several study limitations. One is that Korean local governments only started to consider contracting out to K-Water as one possible institutional option in water service delivery beginning in 2004. Thus, for more meaningful analysis, we need to accumulate more yearly data on performance. Currently, the availability, quality, and equity of water supply services are controversial policy issues in the Korean policy community.

Further research needs to analyze those issues regarding the two institutional arrangements.

In particular, it would be interesting to study whether water supply services are significantly

23 different in terms of availability, quality, and equity before and after water supply services are contracted out to K-Water.

VII. References

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Table 1. Contracting Out of Water Supply Services to K-Water

Supply Capacity Supply Rates Local Government Province Contract Date Contract Period (m³/Day) (%)

Nonsan Chungnam 44,678 59.1 2003. 12. 30 2004 - 2033 (30 yrs) Jeongeup Jeonbuk 60,900 90.5 2004. 12. 06 2005 - 2024 (20 yrs) ¹Sacheon Gyeongnam 76,470 92.5 2005. 07. 26 2005 - 2034 (30 yrs) Yecheon Gyeongbuk 11,000 58.4 2005. 07. 28 2005 - 2034 (30 yrs) Seosan Chungnam 38,860 75.5 2006. 02. 17 2006 - 2035 (30 yrs) Goryeong Gyeongbuk 11,750 76.6 2006. 06. 28 2006 - 2035 (30 yrs) Geumsan Chungnam 16,425 58.9 2006. 06. 28 2007 - 2036 (30 yrs) Dongducheon Gyeonggi 60,000 96.8 2006. 06. 29 2007 - 2036 (30 yrs) ¹Geoje Gyeongnam 96,200 92.6 2007. 11. 01 2008 - 2027 (20 yrs) Yangju Gyeonggi 5,500 96 2008. 02. 05 2008 - 2027 (20 yrs) Naju Jeonnam 79,500 68.9 2008. 03. 14 2008 - 2027 (20 yrs) Danyang Chungbuk 22,900 63.3 2008. 04. 08 2008 - 2027 (20 yrs) Hampyeong Jeonnam 10,550 40.3 2009. 03. 11 2009 - 2028 (20 yrs) Paju Gyeonggi 148,000 91.3 2009. 03. 23 2009 - 2028 (20 yrs) Gwangju Gyeonggi 84,000 87.4 2009. 07. 17 2009 - 2028 (20 yrs) ¹ Sacheon, Geoje, Tongyeong, and Goseong integrated into one water supply system in December 2009 and contracted out to K-Water.

Table 2. Descriptive Results: Public Delivery versus Contracting Out

All Samples Public Delivery Contracting Out Mean Mean Mean (Standard Deviation) (Standard Deviation) (Standard Deviation) Costs of water supply services (1,000 KRWs) 2,648,221.00 2,593,051.00 5,406,712.00 (5,638,059.00) (5,656,784.00) (3,736,035.00) Wages per employee (1,000 KRWs) 11,420.16 10,679.31 48,462.63 (21,317.11) (19,670.80) (50,162.04) User cost of capital 70.83 70.85 70.24 (5.33) (5.36) (4.17) Amounts of water delivered (m³) 15,500,000.00 15,700,000.00 6,916,172.00 (23,800,000.00) (24,000,000.00) (7,254,051.00) Supply capacity (m³) 24,500,000.00 24,900,000.00 7,305,214.00 (38,600,000.00) (38,900,000.00) (4,678,622.00) Water supply rates (%) 67.45 67.37 71.50 (22.46) (22.58) (15.55) Leakage rates (%) 18.34 18.18 26.33 (10.07) (10.02) (9.68) Recovery rates from water charges (%) 73.30 73.32 72.65 (19.58) (19.66) (15.61) Pipe length 472,734.90 470,478.60 585,549.30 (380.847.20) (381,968.30) (304,372.70) Population density 852.11 863.92 261.83 (2,090.24) (2,109.11) (235.49) Labor cost share 0.23 0.23 0.12 (0.18) (0.18) (0.08) Capital cost share 0.77 0.77 0.88 (0.18) (0.18) (0.08) N 1,428 1,400 28

Table 3. Empirical Results: Translog Cost Function

Model 1 Model 2 Model 3 Estimate Estimate Estimate (Standard Error) (Standard Error) (Standard Error) Constant -3.1137 7.3547 -3.1073 (0.8604)*** (1.6421)*** (0.8560)*** lnY -0.1653 -1.4606 -0.1720 (0.1052) (0.1752)*** (0.1047)* lnPL 0.0235 -0.4568 0.0263 (0.0292) (0.0419)*** (0.0292) lnPK 0.9765 1.4568 0.9737 (0.0292)*** (0.0419)*** (0.0292)*** 1 2 /2(lnY) 0.0237 0.0596 0.0237 (0.0067)*** (0.0129)*** (0.0066)*** 1 2 /2(lnPL) 0.0073 0.0574 0.0075 (0.0013)*** (0.0012)*** (0.0013)*** 1 2 /2(lnPK) 0.0073 0.0574 0.0075 (0.0013)*** (0.0012)*** (0.0013)***

(lnY)(lnPL) 0.0127 0.0450 0.0125 (0.0019)*** (0.0027)*** (0.0019)***

(lnY)(lnPK) -0.0127 -0.0450 -0.0125 (0.0019)*** (0.0027)*** (0.0019)***

(lnPL)(lnPK) -0.0073 -0.0574 -0.0075 (0.0013)*** (0.0012)*** (0.0013)*** ln(supply capacity) 0.1243 0.1872 0.1219 (0.0264)*** (0.0397)*** (0.0262)*** Water supply rates 0.0014 0.0164 0.0017 (0.0014) (0.0022)*** (0.0014) Leakage rates -0.0015 0.0293 -0.0005 (0.0020) (0.0034)*** (0.0020) Contracting out -0.7609 -0.4802 (0.2273)*** (0.1155)*** Recovery rates from charges -0.0034 -0.0064 -0.0033 (0.0010)*** (0.0018)*** (0.0010)*** ln(pipe length) 0.4430 0.6662 0.4496 (0.0364)*** (0.0584)*** (0.0363)*** ln(population density) -0.0091 0.1351 -0.0077 (0.0252) (0.0376)*** (0.0251)

Province dummies Yes No Yes

Yearly dummies Yes No Yes

N 1,428 1,428 1,428 R2 (lnTC) 0.9519 0.6843 0.9516 R2 (labor cost share) 0.0617 -0.8273 0.0617 Note: *, **, *** significant at the 10 %, 5 %, and 1 % levels, respectively. 30

Table 4. Test Results on TFP Levels

All Samples Public Delivery Contracting Out Mean-Difference Test

Mean Mean Mean t-statistic (Standard Deviation) (Standard Deviation) (Standard Deviation) -0.0049 -0.0026 -0.1230 0.8316 (0.7589) (0.7618) (0.5917) 1,428 (N) 1,400 (N) 28 (N) 1,426 (df) Note: t-critical values are 1.645, 1.960, and 2.576 at the 10%, 5%, and 1% levels, respectively.

Table 5. Supply Elasticities of Cost and Return to Scale

All Samples Public Delivery Contracting Out

Supply Elasticity of Cost 0.211 0.210 0.221

Return to Scale (RTS) 4.749 4.754 4.529 Note: Elasticities and returns to scale (RTSs) calculated at sample means.

Table 6. Elasticities of Substitution

All Samples Public Delivery Contract Out

Price Morishima Price Morishima Price Morishima Labor, Labor -0.741 -0.739 -0.818 Capital, Capital -0.218 -0.220 -0.115 Capital, Labor 0.218 0.958 0.220 0.959 0.115 0.932 Labor, Capital 0.741 0.958 0.739 0.959 0.818 0.932 Note: Elasticities calculated at sample means.

Endnotes

1 “Delivery” (or “production”) of water supply services needs to be distinguished from “provision” of water supply services (Bae, 2010; Bel and Warner, 2008; Dubin and Navarro, 1988). In public provision, municipalities take full responsibility for the provision of this service, while in private provision private companies do so. But in public provision, water supply services can be also delivered under privatization or contracting out to private companies, as well as direct public delivery. 2 Bhattacharyya et al. (1995) find that private delivery is more efficient in small water supply systems than public delivery, while the former institutional arrangement is less efficient in large water supply systems than the latter. 3 According to the master plan, the Korean central government plans to transfer the offices of waterworks in seven metropolitan governments (Seoul, Busan, Incheon, Daejeon, Daegu, Gwangju, and Ulsan) and Jeju Special Self-Governing Province to public enterprises and allow them to participate in operating and managing newly consolidated water supply systems. 4 In 2006, Cheonan contracted out to K-Water in delivering water supply services only for industrial use for 20 years. But water supply services are still delivered by the local government directly to its residents. 5 Bae (2010) also utilizes a hedonic cost function approach to analyze the effects of different institutional arrangements in municipal solid waste collection, recycling, and disposal on cost savings, efficiency gains, and productivity. 6 Among the 164 local water supply systems in Korea, we do not include water supply systems in seven metropolitan governments and Jeju province, mainly because these water systems are extraordinarily large in terms of size and magnitude of water supply services, compared with the other 156 water supply systems. 7 Demand-side water management tools include water pricing, public information campaigns for water conservation, utilization of efficient water technologies, water recycling and reuse, and direct regulations on water use. For more detailed information, see Coleman (2009) and Wang et al.(2006).