6.4 Who should make the decision on private or public delivery?

The incomplete contracts literature has been extended to consider how, or by whom, the decision on the allocation of residual decision rights should be made in the public sector. This literature is consistent not only with that reviewed in earlier sections of this paper, but also with the idea that the process by which the allocation of rights is made may be very important in reaching an efficient allocation.

Bennedson and Schulz (2011) consider various approaches to delegation of public service decisions in a framework that is general enough to capture delegation within political hierarchies as well as the use of specialist agencies to make decisions about ownership rights. They begin with the trade-off between cost and quality in public-sector service provision identified by Hart et al (1997), and the inability to write complete incentive contracts to address this problem. They then consider different approaches to delegation in the context of a decision about production that may occur in-house or be outsourced. The framework of the model allows for renegotiation of the contract once the in-house or outsource service provider has developed a proposal for cost savings.

The view of the outsourcing decision developed by Bennedson and Schulz (2011) is innovative in their identification of two important effects of delegation:

• The incentive effect. Delegating the rights to negotiate with a service provider to an agent with known preferences may substitute for incentive contracts. For example, if renegotiation is delegated to an agency whose mandate is focused on achieving cost reductions, this will incentivize investment in cost reductions by the service provider.
• The bargaining effect. Delegating the right to determine whether outsourcing will occur will affect the bargaining about the cost of outsourcing options. If the right to decide whether services are outsourced is placed in the hands of an agency with a know preference for in-house provision, this will induce private bidders for outsourced contracts to offer lower prices.

Within this framework, they show that partial delegation, where the principal (government or minister) makes a decision in principle or clearly establishes the preferences for the agency to whom subsequent decisions or bargaining are delegated, is the optimal institution, while full (arms length) delegation is superior to no delegation. The reason is that delegation of decision-making can create incentives in contracting that cannot be replicated in-house or in the absence of delegation, and the bargaining effect means that efficient outsource contracts may be negotiated even when there is limited competition among private providers.

These findings are consistent with a more general literature on the benefits of delegation, and the circumstances in which delegation will be politically feasible. For example, Ludema and Olofsgard (2008) argue that delegation will occur where there is a consensus that time consistency in policy has benefits that may not be achieved because of incentives to attempt to use policy for short-run stabilisation, and the more polarizing or contentious policy decisions are across different constituencies in the electorate. This approach is often used to explain, for example, the delegation of competition policy and monetary policy, but ministerial control of fiscal and taxation policy.