Addressing Agency Problems in Contracting Out Public Services

In order to balance budgets, politicians often resort to privatization. The contracting out literature, especially regarding contracting out public services, discusses a government's lack of capability to manage contracted-out services ('the hollow state'), thereby emphasizing the importance of effective monitoring. (Brown and Potoski 2003, 2006; DeHoog 1990; Pager 1994; Savas 2002; Van Slyke 2003). This paper explains how 'contract failure' can be managed through effective monitoring systems, especially for social programs. The formal model incorporates both monitoring mechanisms of 'fire alarm' and 'police control' (McCubbins and Schwartz 1984). The model describes a government's contracting out as a set of strategic decisions made by both a government (principal) and a vendor (agent). The findings of the model imply that social service provision carries a different weight of political costs to politicians from non-social services and therefore requires a different type of monitoring activity, either fire alarm or police patrol. This model provides a generally applicable paradigm, explaining both social and non-social programs with the same factors, such as 'the government's political cost of poor quality service' (Cg in the model) and 'the government's cost of monitoring' (Cm in the model) but different weights. The findings are empirically tested by applying them to various contracted-out services in cities of Southern California