Public Policy: Using Market-Based Approaches - Department for ...

Public Policy: Using Market-Based Approaches
Incomplete contracts
Ideally, when a service is contracted out to the private sector, the contract should
specify not just the price but also the quality of service to be provided. In
practice, however, it may be difficult to specify quality criteria that are
comprehensive and capable of measurement. This can lead providers to
sacrifice quality in order to minimise costs, or to focus only on measures of
quality that can easily be measured. In general, contracting out will work best
where the opportunities to reduce costs through reducing quality are small or
the effect on quality can be easily measured.
Partly this issue can be addressed by ensuring that contracts have well specified
measures of quality, which are effectively monitored and enforced, although it
may not always be possible to devise and implement such measures. This can
be reinforced, however, if firms know that the quality of the service they provide
(broadly defined) will affect whether they are successful in future tenders. This
can create incentives to maintain quality standards even where they are not
specified in the contract.
Hold-up problem
A related issue is the ‘hold-up’ problem. This problem occurs in contracts when
an initial commitment by one party exposes it to ex post opportunism by the
other. For example, when a contractor considers whether to undertake a large
investment in a specific asset, it will take into account the incentives for the
official managing the contract to renegotiate prices down once the investment
has been undertaken. If the investment is irreversible and has no alternative use
outside the public sector, the government could theoretically ‘hold-up’ the
contractor and capture the entire benefits of the investment for itself without
paying an appropriate transfer fee. This is a problem arising from incomplete
contracts because, if the government could credibly commit to not acting in this
manner, the contractor would face the correct incentives when making his
investment decisions. However, where such commitment is not possible, the
contractor will be aware of the potential for hold-up and consequently invest
less.
Asymmetric information
There may be circumstances where the public sector has less information than
potential service providers, or some service providers possess less information
than others. Both of these cases can raise implementation issues.
The first situation, which is related to incomplete contracts, arises when the
public sector is not able to monitor the efficiency of the service provider. For
example, if costs rise it may be difficult to know whether this is due to
inefficiency on the part of the service provider or factors outside its control. To
address this problem it may be desirable to transfer risk to the service provider
(through a fixed-fee contract, for example) in order to increase its incentives to
minimise costs – although this approach could increase short-run costs and may
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