Institutional Economics Meets the Cost of Capital: Implications for Public Versus Private Infrastructure Delivery

Abstract: Debate over the public versus private-sector cost of capital has been ongoing since at least the publication of Arrow and Lind’s seminal 1970 article. Arrow and Lind conclude that, under certain conditions, the social cost of public-sector-provided capital is lower because project risk can be spread more broadly across taxpayers than across relatively concentrated private investors. The issue’s relevance is growing in the United States due to rising use of public-private partnerships, or PPPs, in major economic sectors. PPPs allow for enhanced private-sector participation in a variety of infrastructure-related activities, including project design, construction, operation, maintenance, and financing. Despite rising use of financial economics to examine this question, analysis of the legal and institutional arrangements surrounding taxpayer- versus private-investor risk bearing has been limited. The vast differences in such arrangements, including the limited liability and transferability of ownership that typically accompany private risk bearing, among others, invite such an analysis. We here apply institutional analysis to analyze the relative social cost of capital. We find that institutional arrangements that have evolved over decades to reduce the cost of private-sector risk bearing are unavailable to taxpayers in their capacity as public investment’s ultimate risk bearers. Our analysis of the arrangements surrounding public- versus private-sector risk bearing casts doubt on Arrow and Lind’s conclusions.