10 Conclusions

10.1  Incomplete contracts and the organisation of the public sector

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 ownerships interests, the benefits of competitive delivery of commercial services that had previously been provided by government monopolies. While the relevance of most of those ideas has not been overturned, they have been supplemented in modern academic analysis by a range of alternative perspectives, some of which imply quite different approaches to public policy, to public-service provision and to the shape and organisation of the public sector.

In particular, we have emphasised that in the last 25 years a theoretical literature has developed that argues that contractual incompleteness affects the boundaries of the firm through allocations of ownership rights. From this perspective, firm boundaries define the allocation of residual control rights, and in the presence of (pervasive) contractual incompleteness, the arrangement of these boundaries is critical for the efficiency of the organisation of economic activity. 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 identification of privatisation with competition under the NPM. This relationship is somewhat misleading because in principle it is possible to have several public-sector organisations competing with each other to supply public services or several management teams competing to run a public enterprise. It is also, of course, possible to have a private firm that is a monopoly. The difference between private and public-sector ownership is therefore not able to be characterised simply as the difference between competition and monopoly. Rather, the importance of public and private ownership results from the fact that they represent allocations of residual decision rights and control over all of those aspects of any activity which cannot (efficiently) be specified explicitly in a contract.

Contractual incompleteness has a wide variety of applications, which include:

• Flexibility in the timing and nature of investment (real options).
• The boundaries between the public and private sectors, both in respect of investment in and management of public facilities, and in the allocation of responsibility for the outcomes of public-service delivery.
• Governance arrangements, the institutional organisation of the state sector, and the balance between decentralisation and specialisation of agencies and central coordination.
• The literature on contractual incompleteness assists in understanding a variety of the problems that have arisen with the development and implementation of policy under the current structures within the public sector, including:
  • The challenges associated with obtaining public benefits from private finance (or public-private partnership) initiatives, especially those arising from the costs of contracts that remove flexibility in the timing and implementation of projects, and the incentives for private investors to make the optimal levels of investment in cost savings and quality enhancements.
  • The difficulties of maximising the investment decisions made across the very large number of entities in the public sector, giving that decision rights are very dispersed, central monitoring agencies lack residual decision rights that would give them the incentives to use the performance-monitoring information collected, and governance boards of at least some Crown entities do not have effective residual decision rights consistent with quality investment decisions.
  • The reasons why delegation of public service delivery to private or community entities may result in superior outcomes by making the entities delivering the services the residual claimants in the success of the relationship with the consumer of the services.