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Public Policy: Using Market-Based Approaches observe that whilst competition does reduce the price of these contracts, quality is maintained or even enhanced. They therefore conclude that the effect of competition is greater on price than quality and the influence of ownership negligible on both. Ways to reduce the quality incomplete contracts problem The single best way to minimise the problems posed by incomplete contracts is to ensure that the initial contract is as ‘complete’ as possible, and to ensure that the resulting contract can be effectively monitored and enforced. In some of the cases reviewed in the literature, where private firms have reduced quality, the problem has been one of lack of monitoring and enforcement of contract provisions rather than incompleteness per se. Domberger and Jensen (1997) note that one example of quality reduction, at the Esmore Correctional Services Corporation at Elizabeth detention centre in New Jersey, USA, which resulted in a riot in 1995, was actually a problem of contract enforcement. In that case the terms of the contract were broken as the prison guards lacked the necessary qualifications to perform their role. Moreover, evidence suggests that monitoring is not particularly costly. The UK Audit Commission (1995) finds that contract monitoring costs amount to no more than a few percent of the contract price. 201 Although a number of studies have found evidence of such quality shading (reduced quality that meets contract requirements) (e.g. Cope, (1995) and Evatt Research Centre (1990)), 202 this is generally considered preventable through the use of proper contract design (Domberger and Jensen, 1997) as long as appropriate monitoring and enforcement mechanisms are in place. However, even if all performance measures cannot be adequately specified, it may be possible to assess the overall quality of the service received when the contract comes up for renewal. If reducing quality adversely affects the possibility of a provider having the contract renewed, then this can provide a strong incentive to maintain quality, even when quality cannot be completely specified. Another means to prevent quality shading is by multi-sourcing, as this allows for ‘yardstick competition’ through the benchmarking of suppliers against one another. The threat of moving demand from poor to high performing suppliers deters suppliers from cutting quality during the life of the contract, and provides incentives to exceed contractual requirements. This effect formed the rationale behind the multi-sourcing approach adopted by the NHS for its National Programme for IT, which committed to selecting at least three different suppliers for its regional contracts and actually chose four. 201 See Audit Commission (1995) Making markets: a review of the audits of the chief role for contracted services. March 1995, London, HMSO. 202 Cope, S. 1995. Contracting-out in local government: cutting by privatising. Public Policy and Administration 10(3). Evatt Research Centre. 1990. Breach of Contract: Privatisation and the Management of the Australian Local Government. Pluto Press: Sydney. 180
Incomplete contracts and optimal contract duration If a contract is incomplete, there is a greater chance renegotiation of terms will be necessary once certain contingencies have been realised. Posner (1972) therefore suggests that franchise contracts should be short so as to avoid problems arising from incomplete long-term contracts. Short-term contracts may reduce the risk of a contract failing by allowing for more frequent renegotiation, but may lead to problems of bidder parity when the contract is re-tendered. Ensuring bidder parity reduces incentives to invest (see Laffont and Tirole 1993, described earlier) but encouraging investment by biasing the tender towards the incumbent lessens competition. Short-term contracts are most likely to discourage investment where investment is specific and non-contractable, and the asset is long-lived. This is the classic ‘hold-up’ problem. In the procurement context, the incumbent supplier may be concerned about exposure to opportunistic behaviour by the government if it undertakes an investment specific to that contract. The incumbent runs the risk of being replaced at the next re-procurement and then being unable to command an appropriate return on its investment from the new entrant. Without a commitment by the public sector to transfer assets at an appropriate rate, such investments may not be made. Williamson (1976), Schmalensee (1979) and Krugman (2002) argue that the gains from outsourcing may be reduced by another case of the ‘hold up’ problem, in which the advantaged incumbent exploits his power opportunistically to extract rent from the government. Affuso and Newbery (2002) look at the problem of contract length and specific investments in relation to the rolling stock operators of the privatised British railway. Here the choice of franchise length reflected the trade-off between periodic contestability for the market and the need to provide sufficient investment incentives. Although short-term demand and long-lived assets could have been expected to impact investment adversely, they do not find a simple relationship between contract length and investment. They find that discretionary investment is higher where contracts are shorter. An explanation for this finding could be that train operators facing sooner re-procurement respond with increased investment to signal their commitment to the regulator and thereby increase the probability of being re-awarded the franchise. Investment towards the end of a franchise also signals aggressive behaviour to potential entrants and increases their costs of entry. ASYMMETRIC INFORMATION Section 12 – Issues in the implementation of market mechanisms Problems of asymmetric information arise when the information available to the government issuing the tender differs from that of the provider of the service. Two examples of problems caused by asymmetric information in the use of marketbased mechanisms are the ability to share risk optimally between parties and the winner’s curse effect in public procurement. These are addressed in turn below. 181
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DTI ECONOMICS PAPER NO.14 Public Po
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DTI ECONOMICS PAPER NO.14 Public Po
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Contents Acknowledgements vi Forewo
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Contents Section 11 Emissions Tradi
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Foreword There is increasing intere
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SECTION 1 Introduction and summary
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Public Policy: Using Market-Based A
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SECTION 2 Using market mechanisms U
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SECTION 3 Lessons for the design an
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SECTION 4 Introduction This part of
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SECTION 7 Market-Based Mechanisms W
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SECTION 8 Framework for assessing m
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Part IV Case Studies 73
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● the Green and White papers behi
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A prison failing to deliver on its
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Table 9.3 Companies providing priso
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Section 9 - Competitive Tendering o
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detect any deviation from a collusi
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at HMPS began as an equal mix of th
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(e.g. lighting). This impact could
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MARKET POWER The full benefits of c
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However, it should be noted that te
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on competition is uncertain. The ab
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Controlling for problems of asymmet
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Procurement process design One way
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however, financial deductions are m
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The Independent Monitoring Board at
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Figure 9.1: Difference between the
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‘While there were staff in the pu
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design the invitation to tender and
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and demand conditions. Second, we d
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DEMAND Anyone can apply to a local
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● Rent deposit guarantee by the l
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The Green Paper stated the Governme
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It was not an objective of ODPM or
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DESCRIPTION OF MARKET MECHANISM The
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Once the outcome is determined, fee
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DEVELOPMENTS OVER TIME The major mo
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