2.2 The theoretical framework

The new public management (NPM) models developed in New Zealand in the late 1980s relied on the application of general management principles, new approaches to accounting (accrual accounting and output-based budgeting), and developments in the literature in economics (Scott and Gorringe, 1989). The key developments in economics that underlay NPM models were associated with institutional economics—a branch of economics concerned with considering the impact of institutional design on performance (Scott, 2001:26). In particular, the literature in institutional economics of the late 1970s and early 1980s was concerned with the theory of the firm, which at that time was built around ideas about transaction costs, principal-agent relationships, and information.

Since the issue was first raised by Ronald Coase in the 1930s, academic economists have developed increasingly sophisticated theories of why firms exist, why some economic activity is organised within the market and some is organised within firms, and how the efficient boundaries of firms are determined. While the majority of this work has been developed in relation to private-sector corporate forms, it has been applied to the public sector with sufficient frequency to make its applicability in this domain clear. In particular, public-sector organisations may be thought of as a type of not-for-profit firm generating policy advice and/or public services, and much of the thinking about the boundaries of the firm is also applicable to the analyses of the scope and organisation of the public sector.

The academic work on principal-agent relationships examined the relationship between those with authority or ownership rights (the principal), and those agents required to undertake activities that maximise value as it is defined by the principal. From this perspective, firms are viewed as mechanisms for reducing moral hazard and adverse selection problems by providing the principal of a firm with the ability to provide incentives to, and engage in active monitoring of, agents (for example, Jensen and Meckling, 1976). The importance of this work for the development of thinking about public management in New Zealand was outlined by Scott (2001:33):

The path to greater efficiency and effectiveness often involves delegation of authority, within constraints, to lower levels within government. In these circumstances, agency theory is helpful in thinking about improvements. This theory is concerned with optimising the transactions involved between the superior and subordinate levels of public management when the goal is to allocate the decision rights to the party with the best capability, information and incentives to achieve performance goals.

The analysis of transaction costs, especially those relating to the governance of relationship-specific investments, was also central to the theory of the firm. Williamson (1979) argued that the transaction costs associated with writing, monitoring and enforcing an external contract determined whether activity was undertaken within the firm or through contracts with external providers. The more specific the asset, and the higher the transaction costs of contracting, the more efficient it would be to undertake activities within the firm. The analysis of transaction costs was central to the analysis of the costs and benefits of contracting out government services versus keeping them in government ownership. Horn (1995) adopts this approach in his treatise on public administration.

Where neoclassical economic models had assumed that information was freely available and costlessly acquired, economists began to consider the implications of building more realistic models in which information was costly to acquire and asymmetrically distributed. The availability of information was recognised as a critical part of decision-making, while at the same time the inevitability of parties not having access to the same information relating to a decision or negotiation was also formally incorporated into economic models.

An increasing academic interest in the role of competition in generating efficiency and in shaping the organisation of markets also influenced the theory of the firm in the 1980s. Recognition that the benefits of competition cannot be replicated by government monopoly, and that it is not possible for the private sector to compete against government departments that can hide costs or run at a loss, resulted in wide-ranging questions about the efficiency of state monopoly provision of goods and services. Where private-sector ownership of activities was feasible, the benefits of competition as a driver of both static and dynamic efficiency overtook traditional theories that had supported the creation of state monopolies, resulting in a wave of privatisation of entities and outsourcing of activities.[2]

The academic literature on which those developments were based would now be characterised as foundational, but unsophisticated. For example, the academic literature of the 1980s provided those interested in management applications with very little assistance in the consideration of:

• Approaches to addressing complex agency and information problems that could not be resolved by incentive and performance management schemes.
• The role of ownership in allocating decision rights, and the implications of this for efficiency in a world where all contracts are incomplete (that is, where not all contingencies relating to the performance of the contract are explicitly addressed).
• The difference between private and government approaches to the analysis of potential investment, particularly in relation to more complex investment issues such as information and investment timing.
• Complex combinations of private and public ownership, management and investment such as those that have been explored in the past two decades under the banner of public-private partnerships, mixed ownership models, private finance initiatives, and private or community delivery of publicly-funded services.