Government outsourcing: Public contracting with private monopoly

Emmanuelle Auriol, Pierre M. Picard 24 November 2009

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Many countries, including Australia, New Zealand, the UK and the US, have chosen to outsource the investment and operation of non-competitive public services, such as water and waste management, public transports, mail services, information and communication technology services, and road infrastructures (Grout 2009). Outsourcing decisions imply the transfer of ownership and control of the facilities or services from public authorities to a private firm. However, economists do not usually recommend such transfers of natural monopolies. Outsourcing is no solution for the lack of competition that prevails in those sectors. Therefore why do governments make such contracts in non-competitive markets?

In the latest issue of the Economic Journal, we present a theoretical study on the costs and benefits of outsourcing in non-competitive contexts (Auriol and Picard 2009). Outsourcing contracts involve the transfer of control and cash-flow rights over a public service or infrastructure to a private firm in exchange for some investment. What distinguishes outsourcing from pure privatisation is that the government contracts with the private firm. We show that government outsourcing to the private sector is most desirable in advanced economies when it is used to deliver high-technology products or to cover low-profitability parts of public services. In very poor countries, outsourcing is beneficial when it leads to the creation of an infrastructure or service that would not otherwise exist.

At the root of our analysis is the government budget constraint captured by the shadow costs of public funds. This standpoint follows the traditional theory of regulation and procurement (Laffont and Tirole 1993) but contrasts with many discussions about privatisation that are based on a soft budget constraint, moral hazard, and production complementarities (e.g. Kornai 1980, Hart et al. 1997). The shadow cost of public funds measures the social cost of the government's economic intervention; any transfer of public money to a firm implies either a decrease in the production of public goods, such as schooling and health care, or an increase in distortionary taxation. Shadow costs of public funds also reflect the macroeconomic constraints that are imposed on national governments' debts levels by supranational institutions (e.g. by the Maastricht treaty on EU member states, by the IMF on some developing countries) and the microeconomic constraints of government agencies that are unable to commit to long-term investment expenditures in their annual or pluri-annual budgets. In developing countries, low income levels and difficulties in implementing effective taxation programs are strong constraints on the government's budget, which leads to high shadow costs of public funds. Because our analysis focuses on the micro-economic outsourcing decision of a particular project, we take the shadow cost of public funds as given.

Regulation vs. outsourcing

Our study compares two regimes. In the regulation regime, a utilitarian government decides to set up a regulated firm run by a public manager. The government controls the investment and production decisions of the regulated firm and is therefore accountable for its profits and losses. Such a combination of control rights and accountability duties is typical of public ownership. The government designs incentive contracts to entice the firm’s manager, who has private information about the firm’s cost, to set the efficient level of production at some informational cost.

In the outsourcing regime, a private investor is invited to serve the market, possibly in exchange for a franchise fee. The private investor gains control and cash-flow rights on the outsourced activity. She controls the investment and production decisions and therefore is fully accountable for her profits and losses. As it is, the private firm is allowed to set the laissez-faire monopoly prices. Yet, because laissez faire is not necessarily optimal, the government can improve welfare by offering ex post contracts to the private firm; that is, once investment costs have been sunk and uncertainties have been solved. Ex post contracts are used by governments to entice the private firm to reduce its prices and increase sales. They are designed to fight the deadweight loss generated by monopoly pricing. However, to accept such ex post contracts, the private investor must at least obtain her laissez-faire profit, which raises her participation constraint to the scheme. The right panel of Figure 1 illustrates this point; the private firm’s profit under outsourcing (in blue) is everywhere larger than the private monopoly profit (in green).

Figure 1. Output and profit under regulation (red), laissez-faire (green) and outsourcing (blue)

We show that the optimal outsourcing contracts are more selective than the contracts under public management; that is, low-cost private firms are offered ex post contracts that lead them to produce the regulated outcome, whereas high-cost private firms are not. As a result the level of production under outsourcing is the maximum of the level of production under laissez-faire and regulation. The left panel of Figure 1 illustrates this point by showing the output levels under regulation (in red), laissez-faire (in green) and outsourcing (in blue).

This result is intuitive. At the contracting stage, the public manager of the regulated firm knows the cost parameter, whereas the government does not. She takes advantage of this information to obtain rents. To prevent managers of low-cost firms from inflating their cost reports, the government must reduce the output levels it asks to high-cost firms. Incentive issues can be so harsh that the output levels of high-cost firms become smaller than the output levels that they would achieve under laissez-faire. The left panel of Figure 1 illustrates this point by showing the firm with cost parameter β0 such that output is the same under regulation and laissez-faire. There is no point to offer an ex post contract to a private firm with this cost because its output level equals the government’s preferred output level. Ex post contracting and laissez-faire would yield the same consumer and producer surpluses. Consider next a firm with a cost larger than β0. If the government proposes an ex post contract to this firm, it is unable to get a surplus larger than under laissez-faire because incentive compatibility obliges it to distort its output downwards. Moreover, any transfer to this firm also increases the rents of all firms with lower costs. Because the government is harmed by both effects, it offers no ex post contract to firms with such large costs. The government thus has no obligation to subsidise the high-cost firms under outsourcing, and expected transfers to private firms are lower. In the right panel of Figure 1, the private firm’s profit under outsourcing (in blue) is smaller than the public manager’s rent under regulation (in red) for most cost parameters.

Outsourcing hence generates a positive fiscal effect because the government is able to terminate subsidies to those money-losing projects and possibly to collect a franchise fee from the private investor. Outsourcing also generates an economic surplus effect, as production can be higher under outsourcing than under a publicly managed firm, as illustrated by the left panel in Figure 1.

Comparing aggregate welfare in regulation and outsourcing scenarios, we show that the set of economic parameters supporting the outsourcing decision is far from negligible. Moreover, we find that outsourcing is more desirable for activities with stronger technological uncertainty or lower profitability and for governments with tougher financial constraints. This provides a useful grid for policy analysis of outsourcing decisions and public-private partnerships in practice.

The pharmaceutical industry is an example of high-technology industry that takes large investment risk and that receives, consistent with the optimal outsourcing scheme, ex post contractual arrangements from governments according to their effectiveness. Private pharmaceutical firms freely choose their investments in R&D and the prices for their patented drugs. But their most effective drugs are subsidised by governments’ health insurance programs. Under such subsidies, consumption is higher than under laissez-faire, where no reimbursement is made.

There are also examples of outsourcing in low-profit sectors. Postal services are outsourced to grocery stores and to gas stations in rural areas of France, Sweden, and New Zealand. Our results suggest that such outsourcing policies are welfare-improving; the consumers get a service at extended business hours, the shop owners get additional revenue, and taxpayers shoulder lower subsidies. Similarly public transport is outsourced to local taxi companies in rural France, Switzerland, and Canada. The European Commission has subsidy programs that promote and finance such “taxibus” services. Taxi companies or drivers invest in their fleets and are free to operate their business. They nevertheless get subsidies to provide a public service that allow them to make higher profits than under laissez-faire. In low-density areas, this additional revenue is crucial for their economic survival. More importantly, this solution offers a better quality of service to the users at a lower public cost.

Finally, in very poor countries, outsourcing takes the extreme form of laissez-faire and is optimal for low-profitability segments. Sub-Saharan African water, electricity and transport services to the middle class and the poor are often offered by private enterprises without any subsidy. Because those countries have very tough budget constraints, even with the monopoly distortion, it is better than not to have a service at all.

References

Auriol, Emmanuelle and Pierre M. Picard (2009), “Government Outsourcing: Public Contracting with Private Monopoly”, Economic Journal, 119(540), 1464-1493.

Grout, Paul (2009), “Private delivery of public services,” Vox Talks, VoxEU.org, 19 June.

Hart, Oliver, Andrei Shleifer, , and Robert W. Vishny (1997), "The Proper Scope of Government: Theory and an Application to Prisons," The Quarterly Journal of Economics, 112(4), 1127-61.

Kornai, János (1980), Economics of Shortage. New York: North-Holland.

Laffont, Jean-Jacques and Jean Tirole (1993), A Theory of Incentives in Procurement and Regulation, MIT Press.

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Topics:  Microeconomic regulation

Tags:  outsourcing, Government outsourcing, natural monopoly, procurement

Professor of Economics, Toulouse School of Economics and CEPR Research Fellow

Professor, University of Luxembourg