Public sector, should the government make or buy?
Samenvatting ‘Incentives and the efficiency of public sector-
outsourcing contracts’
Overall, the majority of empirical research on the subject supports the conclusion that
outsourcing results in reductions in government expenditure.
There are a couple of possible sources for savings associated with outsourcing (not positive):
Quality deterioration (verminderen van kwaliteit)
There are two theoretical foundations for the hypothesis that quality may dete-
riorate when service production is transferred to the private sector.
1. Multitasking approach
Suggests that in instances where an agent is required to perform a number
of different tasks, effort will be allocated to the task that is most easily
measured (and therefore rewarded). Thus, the agent may choose to increase
productivity at the expense of the quality of the output.
2. Cost-reduction incentive may overwhelm quality improvement incentive
A private firm has stronger incentives both to reduce costs and to improve
quality than the public sector. However, the cost-reduction incentive may
overwhelm the quality improvement incentive if quality is difficult to
measure (i.e. it is non-contractible).
Deterioration in employment conditions
Another pervasive criticism of outsourcing is that savings are achieved through
deterioration in employment conditions rather than an improvement in input
utilization. Thus, savings from outsourcing are transfer payments from workers to
managers. Such transfers can take one of two forms: reductions in real wages or
increases in worker effort. Either way, real wage is decreased.
There are also dangers of outsourcing:
Hold-up
Although incompleteness affects all contractual relationships, it presents a particular
problem for outsourcing relationships with the private sector. If an unforeseen event
occurs, the government will have to approach the contractor and renegotiate a
variation to the contract. Private sector firms – with their incentive to maximize
profit – may take the opportunity to increase their price during the course of
contract renegotiations. This phenomenon – which involves appropriation of
economic rent from the government – is referred to in the literature as ‘hold-up’.
once they have been awarded a contract, a (private sector) supplier has considerable
bar- gaining power in the event of contract renegotiation. Savings from outsourcing
will gradually be eroded by private sector firms that ‘ratchet up’ price over time.
Contract design
The contract design is very important in outsourcing, since you are essentially transferring
risk. This has a few consequences:
Moral hazard
Samenvatting ‘Incentives and the efficiency of public sector-
outsourcing contracts’
Overall, the majority of empirical research on the subject supports the conclusion that
outsourcing results in reductions in government expenditure.
There are a couple of possible sources for savings associated with outsourcing (not positive):
Quality deterioration (verminderen van kwaliteit)
There are two theoretical foundations for the hypothesis that quality may dete-
riorate when service production is transferred to the private sector.
1. Multitasking approach
Suggests that in instances where an agent is required to perform a number
of different tasks, effort will be allocated to the task that is most easily
measured (and therefore rewarded). Thus, the agent may choose to increase
productivity at the expense of the quality of the output.
2. Cost-reduction incentive may overwhelm quality improvement incentive
A private firm has stronger incentives both to reduce costs and to improve
quality than the public sector. However, the cost-reduction incentive may
overwhelm the quality improvement incentive if quality is difficult to
measure (i.e. it is non-contractible).
Deterioration in employment conditions
Another pervasive criticism of outsourcing is that savings are achieved through
deterioration in employment conditions rather than an improvement in input
utilization. Thus, savings from outsourcing are transfer payments from workers to
managers. Such transfers can take one of two forms: reductions in real wages or
increases in worker effort. Either way, real wage is decreased.
There are also dangers of outsourcing:
Hold-up
Although incompleteness affects all contractual relationships, it presents a particular
problem for outsourcing relationships with the private sector. If an unforeseen event
occurs, the government will have to approach the contractor and renegotiate a
variation to the contract. Private sector firms – with their incentive to maximize
profit – may take the opportunity to increase their price during the course of
contract renegotiations. This phenomenon – which involves appropriation of
economic rent from the government – is referred to in the literature as ‘hold-up’.
once they have been awarded a contract, a (private sector) supplier has considerable
bar- gaining power in the event of contract renegotiation. Savings from outsourcing
will gradually be eroded by private sector firms that ‘ratchet up’ price over time.
Contract design
The contract design is very important in outsourcing, since you are essentially transferring
risk. This has a few consequences:
Moral hazard
