THEPROPER SCOPE OFGOVERNMENT: THEORY AND ANAPPLICATIONTO PRISONS* OLIVER HART ANDREI SHLEIFER ROBERT W. VISHNY Whenshould a governmentprovide a servicein-house, and when should it contract outprovision? We develop a modelin which theprovider can invest in improvingthe quality of serviceor reducing cost. If contracts areincomplete, the privateprovider has a strongerincentive to engage in bothquality improvement andcost reduction than a governmentemployee has. However ,theprivate con- tractor’s incentiveto engage in cost reduction is typically too strong because he ignoresthe adverse effect on noncontractible quality .Themodel is applied to un- derstandingthe costs and bene ts of prison privatization. I. INTRODUCTION As ageneralrule, government employees provide most ser- vicespaid forwith tax revenues,such as thepolice, the military , operationof prisons, redepartments and schools,collection of garbage,and soon. Y etin somecases, these services are pri- vatized throughgovernment contracting out their provision to private suppliers. Thechoice between in-house provision and con- tractingout has provedto be controversial. Advocates of govern- mentcontracting point outthat private suppliers deliverpublic servicesat alowercost than public employeesdo {Savas 1982 1987; Logan1990}. Thecritics of government contracting, while quibbling with these gures,stress that thequality ofpublic ser- vicesthat private contractorsdeliver is inferiorto that delivered by public employees{AFSCME 1985; Shichor1995}. In this paper wedevelop a theoryof government ownership and contracting *Weare grateful to Matthew Ellman for research assistance, and to Orley Ashenfelter,Gary Becker,PranabBhardan, John DiIulio, John Donahue, Henry Farber,RandallFiler, Edward Glaeser,JosephHarrington, Martin Hellwig, Ste- venKaplan, Lawrence Katz, JohnKwoka, W.BentleyMacLeod, John Matsusaka, SamPeltzman, Rohan Pitchford, Raghuram Rajan, Sherwin Rosen, Jean Tirole, LuisUbeda, Michael Whinston, Chenggang Xu, Luigi Zingales, and two referees forcomments. We have also bene ted from the reactions of seminar audiences at theUniversity of Southern California, California Institute of T echnology,Harvard University,McGillUniversity ,LondonSchool of Economics, University of Chi- cago,Princeton University ,Universityof Miami, Cornell University Law School, ECARE, GeorgeWashington University ,JohnsHopkins University ,Universityof Washington,Seattle, the Industry Economic Conference at Australian National University,Canberra,and the Harvard Political Economy group. Finally ,weare gratefulto the National Science Foundation for support of thiswork. q 1997by thePresident and Fellowsof Harvard Collegeand theMassachusetts Institute ofTechnology . The Quarterly Journal ofEconomics, November1997. 1128 QUARTERLY JOURNALOF ECONOMICS that maythrow light onthecost and quality ofserviceunder al- ternativeprovision modes. Theperspective we adopt is that ofincomplete contracts {Grossmanand Hart1986; Hartand Moore1990; Hart1995}. Suppose that apublic-spirited politician choosesbetween having aservicedelivered by apublic agencyand contractingit out.In the rstcase, the politician hirespublic employeesand gives thememployment contracts specifying what theyneed to do. In thesecond case, the politician signs acontractwith aprivate sup- plierwho in turncontracts with his (orher) employees. If the politician cansign acompleteor comprehensive contract (with eitheremployees or a contractor),he can achieve the same out- comein eachcase. From the traditional incentiveviewpoint, mo- tivating thecontractors and thepublic employeespresents the sameproblem to the politician evenin thepresence of moralhaz- ard and adverseselection. T ounderstand thecosts and bene- ts ofcontracting out, we need to consider a situationwhere contractsare incomplete and whereresidual rightsof control in uncontractedfor circumstances are important in determining agents’incentives. Theassumption of contractualincompleteness is nothard to motivateonce it is recognizedthat thequality ofservicethe gov- ernmentwants oftencannot be fully specied. Indeed, critics of privatization oftenargue that private contractorswould cutqual- ity in theprocess of cutting costs because contracts do not ade- quately guard against this possibility.Critics ofprivate schools fearthat suchschools, even if paid forby thegovernment (e.g., throughvouchers), would nd ways toreject expensive-to- educatechildren, who have learning or behavioral problems, withoutviolating the letter of their contracts. Critics alsoworry that private schoolswould replaceexpensive teachers with cheaperteachers’ aides, thereby jeopardizing thequality ofedu- cation.In thediscussion of public versusprivate healthcare, the pervasiveconcern is that private hospitals would nd ways to savemoney by shirkingon the quality ofcare or rejecting the extremelysick and expensive-to-treatpatients. In thecase of prisons,concern that private providershire unquali ed guards tosave costs, thereby undermining safety and securityof prison- ers,is akeyobjection to privatization. Ourmodel tries to explain bothwhy private contractingis generallycheaper ,and why in somecases it maydeliver a higher,while in othersa lower,qual- ity levelthan in-houseprovision by thegovernment. Many discussionsof privatization lump togetherthe issue of THE PROPERSCOPE OFGOVERNMENT 1129 public orprivate ownershipwith theissue of competition. That is,those who advocate privatization oftendo so on the grounds that private ownershipallows thebene ts ofcompetition to be reaped.We believe that theidenti cation of privatization with competitionis misleading.In principle,it is possibleto havesev- eralgovernment-owned rmscompeting to supply thepublic, or severalmanagement teams competing for the right to run a gov- ernmententerprise (e.g., a prison).It is alsopossible to have a private rmwith noeffective competitors (a monopoly).Our analy- sis isbased ontheidea that thefundamental differencebetween private and public ownershipconcerns the allocation of residual controlrights, rather than thedegree of competition per se. Competitionmay strengthen the case for privatization —in fact weshow that it doesunder some conditions —but onlybecause theallocation of residual controlrights is different under privatization. In thenext section we present a modelof government con- tractingthat focuseson quality issues.The basic idea is that the providerof theservice —whethera governmentemployee or apri- vatecontractor —caninvest his timeto improvethe quality ofthe serviceor to reduce its cost.The cost reduction has an adverse effecton quality.Neitherinnovation is contractibleex ante.How- ever,both types ofinnovation,to be implemented, require the ap- proval oftheowner of theasset, such as aprison,a hospital, ora school.If theprovider is agovernmentemployee, he (or she) needsthe government’ s approval toimplement either improve- ment,since the government retains residual controlrights over theasset. As aresult,the employee receives only a fractionof the returnsto either the quality improvementor the cost reduction. Moreover,an additional limitto how well a governmentemployee canbe effectively compensated for either improvement arises be- causethe employee is replaceable. In contrast,if theprovider is aprivate contractor,hehas the residual controlrights over the asset, and hencedoes not need to getgovernment approval fora costreduction. At thesame time, if aprivate contractorwants toimprove quality and geta higher price,he needs to negotiate with thegovernment since the gov- ernmentis thebuyer of the service. As aconsequence,the private contractorgenerally has astrongerincentive both to improve quality and toreduce costs than thegovernment employee has. But, theprivate contractor’sincentiveto engage in costreduction is typically too strongsince he ignores the adverse impact on quality. 1130 QUARTERLY JOURNALOF ECONOMICS Weanalyze this modelin SectionIII and establish several propositionsconcerning the relative ef ciency of in-house pro- visionand governmentcontracting. In general,the bigger the adverseconsequences of (noncontractible) cost cutting on (non- contractible)quality ,thestronger is thecase for in-house pro- vision.Theef ciency of in-house provision also turns on the strengthof the incentives of government employees, and onthe importanceto the government of generatingquality innovations. Theconclusions emerging from the model are generally ex- tremelyintuitive, including theresult that private provisionis generallycheaper ,but maygenerate either higher or lowerqual- ity.SectionIII alsobrie y addresses akeyomission from the model,namely ,thepossibility ofex post competitionbetween con- tractors,which typically strengthensthe case for privatization. Finally,SectionIII examinesthe consequences of moving away fromthe assumption of benevolent government, and incorporat- ing suchelements as corruptionand patronageinto the model. A fullertreatment of competitionand politics is left tofuture work. In SectionIV weapply ourframework to discuss privatiza- tionof prisons. Should thegovernment contract out the opera- tionsof prisons to private rms,who then have power over incarcerationand treatmentof convicts? Private prisons have beengrowing rapidly in theUnited States, although they still hold onlyabout 3 percentof prisoners.Critics voicea strongcon- cernabout the quality ofprivate incarceration,including the quality ofprisoner life, the incidence of prison violence by in- matesand useof force by guards, escapes,and toa lesserextent rehabilitation.We