Information acquisition and funding for public service agencies: imperfect categorizing

Purpose - The purpose of this paper is to explore the impact of information acquisition for the purpose of differentiating agencies operating in different localities on the design of optimal funding. Design/methodology/approach - This paper is a theoretical study. The focus is on a situation in which agencies providing public services have perfect private information about their cost conditions before the government sets the formula for funding. Findings - The authors show that, using a free signal correlated with costs of operation to differentiate agencies situated in different localities, the government can achieve better welfare for households across regions. However, when there exist non-negligible costs involved in the differentiating process, it may pay to acquire information only if the signal acquired is informative enough, i.e., the correlation between the signal and the agencies’ true cost conditions is strong enough. Social implications - This paper is of interest to academics and policy makers. Acquiring information for tagging can be viewed as a preliminary screening process. Different types are then endowed with distinctly different incentives to control the costs of operating their agencies. Specifically, when the observed cost signal and the true cost conditions of agencies are positively correlated, the government should optimally be more aggressive in distorting the high-cost type’s effort decision by giving less incentive for the low-cost type agencies to cut costs than in the no-differentiation case, and vice versa. Originality/value - This paper is the first study that explores the impact of information acquisition on the design of optimal funding for public service agencies.