Summary

The new public management of the 1980s was based in part on a range of important new insights developed by academic economists over the preceding 15 years. Those insights were based on thinking about transaction and agency costs as central to defining the boundaries of the firm and the governance relationships within them, separation of purchase and ownership interests, and the benefits of competitive delivery of commercial services that had previously been provided by government monopolies. This literature focused on contractual incompleteness (the inability to write contracts that explicitly address every contingency relevant to the contract) as a driver of transaction costs, and on transaction cost minimisation as a driver of organisational boundaries.

In this paper, we explore the theoretical literature developed in the last 25 years which focuses on allocation of residual decision rights through ownership decisions as the fundamental response to contractual incompleteness. The ability to exercise residual control rights increases incentives to make relationship-specific investments by improving the ex post bargaining position of an asset owner. Asset ownership should therefore be assigned to those with the potential to make the most important (value-enhancing), relationship-specific investments.

As an example, consider the choice between public and private ownership. This choice defines allocations of residual decision rights and control over all of those aspects of any activity which cannot (efficiently) be specified explicitly in a contract. Debates that focus on issues such as who collects the dividends generated by the firm completely miss the point that decisions on ownership should be driven by the desire to allocate residual decision rights to the party most able to make value-maximising decisions about the operation of the firm.

Decisions to undertake investment projects will often be incomplete in the sense that different aspects of the implementation, including the timing of the investment and the phasing of the investment, will often be at the discretion of the party implementing the investment rather than the party providing overall approval for the project. The residual decision rights are often captured in the ability to exercise “real options,” that is, options relating to the timing or phasing of investment that are extinguished once investment proceeds. Public infrastructure decisions are often driven by political imperatives to specify start and completion dates ex ante, which carries with it two dangers; that the removal of flexibility about start dates will undermine value or increase costs associated with the project, and that the project will be undertaken immediately, when a delay in starting would maximise efficiency.

The importance of allocating incomplete contractual rights over real options carries over to public-private partnerships. Where these require the private infrastructure provider to start construction on a particular day or remove from the private infrastructure provider the residual decision rights to determine whether investment in research on innovations will take place, and whether the innovation will be implemented, much of the value of involving a private party in the project may be lost. The incomplete contracts literature provides the potential to get past what had become a rather sterile and ideological debate on the role of the private sector in the ownership and management of facilities delivering public services by refocusing the debate on the allocation of residual decision rights that will add the most value to the project.

For service firms, in particular, the customer base is a critical asset that will determine the success of the firm, and this is especially true where long-term customer relationships are important. In this context, the literature on incomplete contracts suggests that the allocation of residual ownership rights over assets such as the customer base of a service firm may be a critical determinant of the success of the firm. Government is involved in wide range of contracting for services, and these should be organised so as to allocate residual decision rights in the customer relationship to the parties that add the most value to the relationship. From this perspective:

• The importance of the relationship between general practitioners (GPs) and their patients provides an explanation for the fact that GPs are the part of the health sector that in almost every country is privatised (that is, GPs, not the government, “own” the relationship with the patient).
• Community-based lending programmes (such as microfinance) may be effective in utilising relationships and moral suasion within communities to replace high cost monitoring and enforcement mechanisms used by loan companies and loan sharks.
• Whānau Ora and other community-based initiatives can perhaps be seen as about providing a community organisation with ownership of the relationship with the client/patient.

In a world where contracts are incomplete, corporate governance defines the rights to make ex post decisions in relation to unspecified contingencies shifting the focus of the analysis of governance away from agency (incentive) problems and towards decision and investment problems. A common justification for creating Crown entities is the substance, or perception, of greater independence from ministerial direction by comparison with departmental heads. But where a minister has ultimate responsibility for the performance and strategic direction of the organisation, the minister will wish to exercise residual decision rights on most matters of importance. These problems could be resolved in three complementary ways:

• Separate those entities in which the boards serve primarily as advisory boards rather than as governance boards, and reconstitute them as such. This would make it clear that for those entities, the minister rather than the board had the responsibility for addressing contractual incompleteness.[1]
• Establish a much clearer distinction between public-sector organisations where governance can be effectively delegated to a board of directors, and enshrine that separation from ministers much more clearly in the constitutions of those entities. Where contracts are highly incomplete, then governance would be improved by making the boards advisory boards only.
• Change the structure of the boards that remain, making them smaller to ensure that the whole board can be informed of the minister's views, and leave them to make decisions.

A key issue for the public sector in New Zealand is the need to generate greater coordination between a large number of public-sector agencies. Much of the academic literature addressing the issue of coordination is in the context of consideration of a choice between a “divisional structure” and a “functional structure,” or a centralised or a decentralised allocation of residual decision rights within a hierarchical structure. In the public sector, this literature may be translated as suggesting that specialised departments and agencies are better at identifying projects (have more local knowledge), worse at selecting which projects to invest in, and more efficient in implementing the projects that are chosen. If the identification of projects ex ante is not critical (for example, if this is driven by ministers rather than by the specialised knowledge of civil servants), but decisions about which projects to invest in are critical, then large hierarchical government departments with multiple divisions may be preferred.

The more the public sector focuses on policy, as opposed to service delivery and asset ownership, then the more likely it is that coordination will be important. Thus it is likely that a smaller number of larger public-sector organisations will be preferred, because they may provide individual units with incentives to develop specialised expertise and collect information while also providing high level coordination of the investment and resource-allocation decisions made.

The literature on incomplete contracts, therefore, suggests new ways of thinking about problems, and directions for organisational change that might result in a 21^st century public sector being structured around:

• Fewer public-sector organisations and further thinking about contestability in policy advice and service delivery both within and between large public-sector organisations.
• Greater clarity in monitoring, with only one central monitoring agency being given “ownership” of public-sector performance.
• A clearer distinction between organisations where governance can be delegated to a board, and organisations where the minister retains residual decision rights.
• Less public ownership of service delivery, with wider delegation of responsibility for investment in outcomes and customer relationships to private or community service delivery organisations.
• Increased levels of private ownership of state infrastructure assets, with the contracts taking advantage of the recent literature on optimal contractual arrangements.
• Greater attention to the structure of compensation and reward, both to change incentives and to change the type of people that are attracted to public-sector organisations.

Each of these areas of policy development will of course need to be the subject of more detailed consideration and application of the framework that we have provided before explicit policy recommendations could be provided.