THEPROPER SCOPE OFGOVERNMENT: THEORY ANDANAPPLICATIONTO 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 the provider 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 beneŽ ts of prison privatization.

I. INTRODUCTION As ageneralrule, government employees provide most ser- vicespaid forwith tax revenues,such as thepolice, the military , operationof prisons, Ž 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 theseŽ 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 beneŽ 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 theŽ 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- Žts 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 speciŽed. 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 Žnd 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 Žnd ways to savemoney by shirkingon the quality ofcare or rejecting the extremelysick and expensive-to-treatpatients. In thecase of prisons,concern that private providershire unqualiŽ 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 thebeneŽ ts ofcompetition to be reaped.We believe that theidentiŽ cation of privatization with competitionis misleading.In principle,it is possibleto havesev- eralgovernment-owned Ž 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 Žrmwith 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 efŽ 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.TheefŽ 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 Žrms,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 show that ourmodel can be used to organize, if notresolve, the debate over prison privatization. Ourresults may help in thinkingabout other government servicesas well.The parameters of the model, namely ,thead- versequality effectsof cost reduction, the importance of quality innovation,the incentives of government employees, as wellas possibilities ofcompetition which we do not model, may shed light onthewisdom of privatization ofsuchactivities as defense procurement,garbage collection, police and armedforces, educa- tion,and health.In SectionVI wediscuss theseexamples and considersome of thenew issues they raise. Oursis notthe Ž rstnormative analysis ofgovernment con- tracting.1 Someof the issues addressed in ourpaper areraised in

1.There is also a considerableliterature on positive aspects of contracting; see,e.g., Shleifer and Vishny {1994} and Savas {1982, 1987}. THE PROPERSCOPE OFGOVERNMENT 1131 thenow-classic book by Wilson{1989}. Economistsworking in this areahave generally focused on traditional adverseselection and moralhazard problemsraised by contracting{Laffont and Tirole1993; Tirole1994}, as wellas oncompetitive and anti- monopolyproblems following privatization {Vickersand Yarrow 1988}. Somerecent studies haveexamined contractual incom- pleteness{Schmidt 1996; Shapiro and Willig 1990; Laffont and Tirole1993}. Unlikeour work, they have emphasized informa- tionallosses from contracting or the costs of having multiple bosses.Theoretically ,ourpaper is newprimarily in deemphasiz- ing therole of incompleteinformation in contracting,and empha- sizing quality issues.In this regard,our paper is relatedto the workof Holmstromand Milgrom{1991, 1994}, who,in acompre- hensivecontracting framework, show that providing an agent with strongincentives to pursue one objective, such as proŽts, canlead tohis shirkingon otherobjectives, such as quality.Our frameworkis different fromtheirs, although the issues we are interestedin aresimilar .In addition, theexisting literature is primarily theoretical,and doesnot go into the problems of speciŽ c sectors,such as prisons,in muchdetail. 2

II. THE MODEL A.Basic Assumptions In this sectionwe present a simplemodel of the choice be- tweenthe public and private provisionof agood,such as prison, hospital,or schoolservices. Suppose that society,representedby thegovernment, wants acertaingood or serviceto be provided. We assume that consum- erscannot buy this gooddirectly in themarketplace, e.g., because it is apublic good. 3 Onepossibility is tocontract out the provision ofthis good,e.g., the government can write a contractwith apri- vatecompany to run a prisonfor Ž veyears. 4 Asecondpossibility is toprovide the good “ in-house,”e.g., the government can ar-

2.There are some exceptions. For example, Vickers andY arrow {1988}dis- cussthe possible decline in quality at British T elecomfollowing privatization and pricecap regulation.Domberger ,Halland Li {1995} examine the consequences forprice and quality of contracting outcleaning services. 3.This assumption makes good sense in the case of prisonsbut is more con- troversialin the case of schools or hospitals. 4.An alternativeinterpretation is thatthe government regulates the private companyfor Ž veyears. In this case the contract simplydescribes the regulatory policy.Wedo not deal explicitly with regulation in this paper ,butnote that any regulatorypolicy can be interpretedas an (incomplete) contract andvice versa. 1132 QUARTERLY JOURNALOF ECONOMICS rangefor public employeesto run the prison. The model is based onthe idea that thecrucial distinction betweenthese arrange- mentsconcerns who has residual rightsof control over the non- humanassets used to provide the service— we call theseassets the“ facility F”(e.g.,the prison). If thegood is publicly provided, thenthe government (represented by abureaucrat),as owner, has residual controlrights over the facility .If thegood is pri- vatelyprovided, then the private provider,as owner,has residual controlrights over the facility .Residual controlrights matter be- causethey determine who has theauthority to approve changes in procedureor innovationsin uncontracted-forcontingencies. 5 Wesuppose that thefacility —public orprivate— is runby a singlemanager/ worker, M. Thereis alsoa singlebureaucrat or politician,represented by G. Westart by consideringthe case wherethe bureaucrat perfectly represents the interests of soci- ety;i.e., there is noagency problem between the bureaucrat and society.6 Laterwe consider self-interested bureaucrats and politicians. Weassume that G and M areable towrite a long-termcon- tractspecifying someaspects ofthegood or serviceto be provided and theprice. In fact, wesuppose that along-termcontract is requiredin thecase where F is private in orderto support rela- tionship-speciŽc investments. 7 Wecall thegood thus describedin thecontract the “ basic”good and denoteits priceby P0. P0 has different interpretationsaccording to whether the facility F is private orpublic. If F is private,i.e., M owns F, then P0 is the price that M as an independentcontractor receives for providing thebasic good.If F is public, i.e., G owns F, then P0 is the wage that M receivesas an employee.In thelatter case provision of thebasic goodcan be regarded as part of M’sjobdescription; i.e.,

5.See Grossman and Hart {1986}. What may be more important is notwho ownsthe physical prison, but who has the right touse it (perhaps for a restricted periodof time). For example, the government may own the prison, but sell the right tooperate it to a privatecompany for n years(a franchising arrangement). Inthis case, the private company has residual control rights during the n year period.In this paper we do not distinguish between physical ownership and pos- sessionof the right touse the prison. 6.T obemore precise, we assume that G’sutilityfunction is given by the welfareof therest of society ,excluding M.AjustiŽcation for this is that the politi- calprocess aligns G’sandsociety’ s interests(since M hasnegligible voting power, hisinterests receive negligible weight). As will become clear, if G placedthe same weight on M’sutilityas on the rest of society ,theŽ rst-bestcould be achieved. 7.We do not model these relationship-speciŽ c investmentsexplicitly .They mightcorrespond to physical investments, e.g., building the prison. For the idea thata long-termcontract isrequired to support relationship-speciŽ c investments, seeKlein, Crawford, andAlchian {1978} and Williamson {1985}. THE PROPERSCOPE OFGOVERNMENT 1133

M doesnot get paid unlesshe provides the good. Although G and M canspecify someaspects ofthe good or servicein advance,we suppose that thereare others that they cannotspecify .Wehave in mind that variouscontingencies can arisewhich call forsome modiŽ cation of the basic good.For in- stance, M can suggesta way tomodify theprison to increase secu- rity.Alternatively, M mayŽ nd away toreduce costs by hiring cheaper(or fewer) guards. Ourassumption is that thereare so manypossible contingencies ex antethat it is impossibleto antici- pate themall and contracton how to deal with themin advance. 8 Instead theparties revisethe contract ex post onceit is clear what therelevant contingencies are. We refer to the basic good modiŽed toallow forrelevant contingencies as the“ modiŽed good.” ThemodiŽ ed good yields abeneŽt B tosociety and coststhe manager C to produce. C is acostborne directly by M. For ex- ample, B mightbe the social beneŽ t fromhaving aprisonwith fewŽ ghts betweeninmates and well-fed and healthyprisoners. Although B cannotbe measured or veriŽed (it doesnot show up in any accounts),we suppose that it canbe represented by adollar amount.Similarly , C canbe represented in dollars. Themanager can manipulate B and C throughprior effort choices.We assume that M can devoteeffort to twotypes of“ inno- vation”relative to the basic good:a costinnovation and aquality innovation.We suppose that acostinnovation leads toa reduc- tionin costs C but is typically accompaniedby areductionin quality (i.e., B).Similarly,aquality innovationleads toan in- creasein quality,but is typically accompaniedby an increasein costs.We write

B = B0 - b(e) + b(i),

C = C0 - c(e), where e, i denoteeffort devoted to the cost innovation and quality innovation,respectively , c(e)$ 0is thereduction in costcorre- sponding tothe cost innovation; b(e)$ 0is thereduction in qual- ity correspondingto the cost innovation; and b (i) $ 0 is the quality increasenet of costs from the quality innovation. 9 The function b plays akeyrole in this model:it measureshow much

8.For a further discussionsee Hart {1995}. 9.We need to keep track oftheseparate cost and quality components of the costinnovation ( c and b),butnot of thequality innovation. 1134 QUARTERLY JOURNALOF ECONOMICS

(noncontractible)quality falls becauseof a(noncontractible)cost cut,and henceserves as thevariable that criticsof privatization focus on. Wemake standard assumptionsabout the convexity ,concav- ity,and monotonicityof b, c, and b : b(0) 5 0, b9 $ 0, b0 $ 0; c(0) 5 0, c9 (0) 5 ¥, c9 . 0, c0 , 0, c9 (¥) 5 0; b (0) 5 0, b 9 (0) 5 ¥, b 9 . 0, b 0 , 0, b 9 (¥) 5 0; c9 2 b9 $ 0.Note that theassumptions c9 2 b9 $ 0, b 9 . 0say that thequality reductionfrom a costinnovation doesnot offset the cost reduction; and thecost increase from a quality innovationdoes not offset the quality increase.The for- mer,in particular,is animportantsubstantive assumption,since onecan imagine in principle that costcutting by acontractor (e.g.,failing totrain prisonguards) producessocial damage in excessof cost savings. Our assumptions rule out this case,al- thoughit canbe easily analyzed. Themanager ’sexante effort cost must be added to C to get M’soverallcosts. We write total effort costs as e 1 i, and assume azerointerest rate (no discounting). Hence M’soverallcosts are 10

C + e + i = C0 - c(e) + e + i. Oneimportant assumption we makeis that boththe cost and quality innovationscan be introduced without triggering a breachof thecontract for the basic good.That is, although each innovationleads toa changein quality (in thecase of the cost innovation,a reductionin quality), theinitial contractis sufŽ- cientlyvague or “incomplete”that neitherinnovation violates it. Wealso assume that i, e, b, and c areobservable to both G and M,but arenot veriŽ able (tooutsiders) and hencecan- notbe part ofan enforceablecontract. Similarly , G’s beneŽts and M’scostsare observable, but notveriŽ able ortransferable, whichmeans that revenueand cost-sharingarrangements are infeasible. 11 Wesuppose that G and M areat leastpartially lockedinto eachother once their relationship is underway .SpeciŽcally ,there is nofacility available otherthan F that cansupply society,and thereis noother potential customer for the service (e.g., a prison)

10.In anearlierversion of thispaper, we assumed a morecomplicated cost- of-effortfunction in which e and i weresubstitutes (along the lines of themulti- taskingwork ofHolmstrom and Milgrom {1991}). The current modelgenerates simplerand easier-to-interpret results. 11.For a moreextensive discussion of veriŽ ability ,noncontractibility,and revenueand cost-sharing arrangements, see Hart {1995}. THE PROPERSCOPE OFGOVERNMENT 1135

FIGURE I apart from G. However, M’slaborservices may be partially sub- stitutable (seebelow). Finally ,weassume that M and G are risk neutraland that thereare no wealth constraints. A time-lineis presentedin FigureI.

B.Default Payoffs As noted,the parties want torenegotiate the contract at date 1oncethey learn the nature of potential quality improvements and costreductions. We assume that G and M divide thegains fromrenegotiation according to Nash bargaining, i.e.,they split thesurplus 50:50. Thismeans that theparties’ default payoffs— that is,what occursin theabsence of renegotiation— in uence Žnal payoffs. Wetake the point ofviewthat any costor quality innovation requiresthe agreement of theowner of thefacility F,sinceimple- mentingthese innovations involves a changein theway F is used. Only theowner (the possessor of the residual controlrights) has theright to approve such a change.Thus, in thecase of apublic facility, G needsto agree to any costor quality innovation, whereas,if thefacility is private, M canimplement these innova- tionswithout G’sagreement.However, even if thefacility is pri- vate,it is notin M’sinterestto introduce a quality innovation withoutthe approval of G sinceno payment will beforthcoming foran uncontracted-forquality improvementunless G agrees to makeit; i.e., unless a newcontract is written. It remainsto discuss theextent to which the fruits of M’s efforts e and i areembodied in M’shumancapital. Suppose that if M has an idea abouthow to reduce costs or increase quality thena fractionof thebeneŽ ts ofthis idea requires M’sparticipa- tion,but theremainder can be realized without M becausesome aspects of M’sideas becomepublic knowledge(at leastwithin the organization).In particular, assumethat, in thecase where F is public, G canrealize a fraction0 # (1 2 l ) # 1ofthe net social 1136 QUARTERLY JOURNALOF ECONOMICS gains 2 b(e) 1 c(e) 1 b (i)frominnovation without M by hiring a different managerand paying himat cost.If F is private, G can obtain noneof these beneŽ ts since M has theresidual control rightsand canprevent any innovations(and canalso avoid being replaced).The parameter l is veryimportant, since it effectively measuresthe weakness of the incentives of governmentemploy- ees.In thecase l 5 1,the public employee(warden) is irreplace- able,and hencecan commandthe same share of the total rents in thenegotiation with G as aprivate manager(but, in contrast toa private manager,apublic warden will haveto get G’s permis- sionto implement a costreduction). Wecan sum up theabove discussion as follows. (A) If F is privately owned,then, in theabsence of renegotia- tion, thecost innovation is implemented(since it is in M’sinterestto implement it and M has theresidual con- trolrights), but thequality innovationis not(since no paymentfrom G will beforthcoming). That is, G’s default

payoff is B0 2 P0 2 b(e) and M’sdefault payoff is P0 2 C0 1 c(e) 2 e 2 i. (B) If F is publicly owned,then, in theabsence of renegotia- tion, bothcost and quality innovationsare implemented. However, G mustreplace M and hencegets only a share (1 2 l )ofthegains fromthese innovations. That is, G’s

default payoff is B0 2 P0 1 ( 12 l ) {2 b(e) 1 c(e) 1 b (i)},

and M’sdefault payoff is P0 2 C0 2 e 2 i. C.TheFirst-Best Consideras abenchmarkthe Ž rst-best situationwhere e and i arecontractible (or equivalently ,wherelong-term contracts de- scribingthe modiŽ ed goodcan be written). In this case, G and M would choose e and i tomaximize the total net surplus fromtheir trading relationship,and divide thesurplus betweenthem using lump-sumtransfers. That is, in theŽ rst-best, G and M solve (1) max[-b(e) + c(e) + b(i) - e - i]. e,i Givenour assumptions, (1) has auniquesolution ( e*,i*), charac- terizedby Žrst-orderconditions: (2) -b¢(e*) + c¢(e*) = 1, (3) b¢(i*) = 1. THE PROPERSCOPE OFGOVERNMENT 1137

At thesocial optimum, the marginal social beneŽ t ofspending extraeffort to reducecosts, measured to take account of marginal quality deterioration,must equal the marginal cost of that extra effort,which equals one. Similarly ,themarginal social beneŽ t of spending extraeffort to improve quality mustequal the marginal costof that extraeffort, which again equalsone.

D.Equilibrium underPrivate Ownership Suppose that M owns F.Thenin light of( A),therenegotia- tiontakes place overthe quality innovation.The gains fromrene- gotiationare b (i),whichare split 50:50. (Thereis symmetric informationabout i.)Theparties’ payoffs are

(4) UG = B0 - P0 + 1/ 2b(i) - b(e),

(5) UM = P0 - C0 + 1/2b(i) + c(e) - e - i. Notethat because M canreduce costs without seeking G’s ap- proval, G bearsthe full bruntof quality deteriorationresulting fromcost reduction. Sincethe parties areassumed to have rational expectations,

M chooses e and i to maximize UM,that is,to solve (6) max1/ 2b(i) + c(e) - e - i . `e,i { }

Denotethe (unique) solutionby ( eM ,iM) (where M stands forown- ership by M).TheŽ rst-orderconditions for (6) are

(7) c¢(eM ) = 1,

(8) 1/2b¢(iM ) = 1. Thereare two deviations from Ž rst-best here.First, M ignores the deteriorationof quality resultingfrom cost reduction, and hence exaggeratesthe social beneŽ t ofcost reduction. Second, because M must get G’sapproval toimplementa quality improvement,on themargin he gets only half thebeneŽ ts ofthat improvement, whichstunts his incentiveto improve quality .

Thetotal surplus SM under M’sownershipis thengiven by

(9)SM = UG + UM = B0 - C0 - b(eM ) + c(eM ) + b(iM) - eM - iM .

The price P0 is chosento allocate this surplus betweenthe parties accordingto their relative bargaining positionsat date 0.Thefor- mula for SM reects the fact that theparties bargain efŽciently 1138 QUARTERLY JOURNALOF ECONOMICS expost, but thereis adistortionin relationship-speciŽc invest- ments e and i.

E.Equilibrium underPublic Ownership Suppose that G owns F.Thenin light of( B)therenegotiation takesplace overthe fraction l ofboth the cost and quality innova- tions that G cannotappropriate: l {2 b(e) 1 c(e) 1 b (i)}.Thegains aresplit 50:50, and sotheparties’ payoffs are

(10) UG = B0 - P0 + (1 - l /2){-b(e) + c(e) + b( i)},

(11) UM = P0 - C0 + l /2{-b(e) + c(e) + b(i)} - e - i. Notethat, in thecase l 5 1,when the manager is completely irreplaceable,the parties split thegains frominnovation 50:50. M chooses e and i to solve (12) max[l / 2{-b(e) + c(e) + b(i)} - e - i]. e,i

Denotethe (unique) solutionby ( eG ,iG) (where G stands forowner- ship by G).TheŽ rstorder conditions for (12) are

(13) l/2 (-b¢(eG) + c¢(eG)) = 1, (14) l/2b¢(i) = 1. In contrastto the private ownershipcase, because the publicly employed M needsto negotiate the cost reduction with G, he takesaccount of quality reductionsthat mayresult from cost- cuttinginnovations. However, there are new distortions in the caseof public ownership.First, for both quality and costinnova- tion,the public managerneeds the approval of G and hencesur- rendershalf thegains fromtrade. Second, if l , 1,the public managercan be replaced, and hencehas evenweaker incentives toinnovate. Both of these factors stunt apublic manager’sin- centives.

Thetotal surplus SG under G ownershipis givenby

(15) SG = UG + UM = B0 - C0 - b(eG) + c(eG) + b(iG) - eG - iG .

Again theprice P0 is chosento allocate the surplus at time0 ac- cordingto relative bargaining power.

F.TheChoice of Ownership Structure Theoptimal ownershipstructure is theone that producesthe largesttotal surplus (thedivision ofsurplus canalways bead- THE PROPERSCOPE OFGOVERNMENT 1139

justedthrough P0).Thatis, G ownershipis superiorto M ownership

(16) Û SG > SM

Û - b(eG) + c(eG) + b(iG) - eG - iG > - b(eM ) + c(eM )

+ b(iM ) - eM - iM . Renegotiationunder symmetric information ensures that all ownershipstructures yield an expost efŽcient outcome. The only differencebetween the ownership structures concerns the choice ofthe ex anteinvestments e and i.

III. ANALYSISOFTHE OPTIMAL OWNERSHIP STRUCTURE A.Main Results Acomparisonof (1) and (6) showsthat private ownership leads totwo distortions relative to the Ž rst-best.First, M ignores thefact that e reducesnoncontractible quality b(e); in other words,that hedamages G throughhis effortto reduce costs. Sec- ond, M places 50 percentweight on thegains fromquality innova- tion b (i)as opposedto 100 percentweight. It followsimmediately fromthe Ž rst-orderconditions (2), (3), (7), (8), and concavitythat e is inefŽciently high and i is inefŽciently low under private ownership.

PROPOSITION 1. eM . e*, iM , i*. Theprivate ownershipequilibrium is illustrated in FigureII. Considernext public ownership.A comparisonof (1) and (12) showsthat underpublic ownership, M doesworry about the dam- age b(e).The reason is that M cannotimplement the cost reduc- tionwithout G’spermissionand sothey bargain aboutthe net surplus 2 b(e) 1 c(e)fromthe cost-reducing innovation. However, Mplaces weight l /2onthe gains fromcost innovation 2 b(e) 1 c(e)and onthe gains fromquality innovation b (i),as opposedto 100 percentweight in theŽ rstbest. It followsfrom the Ž rst-order conditions(13)– (14) that e and i areboth inefŽ ciently low under public ownership.Moreover , i is lowerunder public than under private ownershipunless l 5 1;i.e., unless M is irreplaceable.

PROPOSITION 2. eG , e*, iG # iM , i* (with iG , iM unless l 5 1). Thepublic ownershipequilibrium is alsoillustrated in FigureII. Thetrade-off betweenpublic and private ownershipis now 1140 QUARTERLY JOURNALOF ECONOMICS

FIGURE II THE PROPERSCOPE OFGOVERNMENT 1141 fairly clear.Privateownership leads toan excessivelystrong in- centiveto engage in costreduction ( eM . e*)and tomoderate — althoughstill tooweak —incentivesto engage in quality improve- ment (iM , i*).Public ownership removes the excessive tendency toengage in costreduction but replacesthis with aweakincen- tiveto engage in bothcost reduction and quality improvement. Whicharrangement is superiortherefore depends onwhich dis- tortionis lessdamaging. Thenext two propositions provide conditions under which private ownershipand public ownershipcan be ranked.

PROPOSITION 3.

(1) Suppose that thefunction b(e)is replacedby u b(e), where u . 0. Then for u sufŽciently small, private ownershipis su- periorto public ownership. (2) Suppose that thefunction b(e)is replacedby u b(e) and the function c(e)is replacedby f c(e), where u , f . 0. Then, for u , f sufŽciently small and l , 1,private ownershipis superior topublic ownership.

Part(1) ofProposition3 followsfrom the fact that,as u ® 0, thedamage to quality fromcost reduction disappears. Under theseconditions, private ownershipleads tothe efŽ cient choice of e (since c9 (e) ø 2 b9 (e) 1 c9 (e)). Sincethe level of i is always closerto theŽ rst-best underprivate ownershipthan underpublic ownership,private ownershipdominates public ownership.Part

(2) followsfrom the fact that,as u , f ® 0, e*, eM and eG all con- vergeto zero. Thus, only the choice of i matters;private owner- ship is betterthan public ownershipbecause it yields alevelof i closer to i*. Proposition3 has averynatural interpretation.There are basically twocases when private ownershipis unambiguouslysu- perior.The Ž rstcase is whenthe deterioration of quality from costreduction is small.In this case,the stronger incentives that aprivate contractorhas toreduce costs and improvequality are bothdesirable. The second case is whenthe opportunities for cost reduction(and hencethe damage to quality as well) aresmall and thegovernment employees have relatively weak incentives (l is small).In this case,the private contractorwould not domuch of the potentially damaging costreduction, and his strongerincentive to make quality innovationsgives him the 1142 QUARTERLY JOURNALOF ECONOMICS edgeover in-house provision. Both of these are extremely intui- tive cases. Thecases where in-house provision is superiorare given by thefollowing result:

PROPOSITION 4. (1) Suppose that b(e) ; c(e) 2 s d(e), where s . 0. Then for s sufŽciently small and l sufŽciently close to 1, public owner- ship is superiorto private ownership. (2) Suppose that b(e) ; c(e) 2 s d(e), where s . 0. Suppose alsothat thefunction b (i)is replacedby t b (i), where t . 0. Then for s , t sufŽciently small public ownershipis superior toprivate ownership. Part(1) followsfrom the fact that as s ® 0thesocial gains fromcost reduction, 2 b(e) 1 c(e),convergeto zero: the quality damagefully offsetsthe cost savings. Thus, the weak incentives forcost reduction under public ownershipare socially efŽ cient. In contrast,the incentives for cost reduction under private own- ershipare inefŽ cient, since the private ownerignores the sub- stantial damage b(e). If l is closeto 1, the incentives for quality innovationunder public ownershipare similar to those under pri- vateownership, and sopublic ownershipdominates private ownership. Part(2) replacesthe condition l closeto 1with thecondition that t is small.In this case i*, iM and iG areall approximately zero,and soonly the choice of e matters.For s small,public own- ershipis superiorto private ownershipbecause it deliversa so- cially moreefŽ cient level of e. Proposition4 as wellhas averynatural interpretation.Pub- licownership is mostlikely to be better when the adverse effect ofcostreduction on quality islarge.But that is notenough. For public ownershipto be deŽ nitely superior ,it mustalso be the case that eitherquality improvementis unimportantor that govern- mentemployees do not have weaker incentives in quality im- provement (l is large).If oneof thelatter conditions holds, then private contractorsare not signiŽ cantly superiorat improving quality,and hencepublic ownershipis preferred. 12

12.We have analyzed private ownership under the assumption that the pri- vateowner actually manages the Ž rm.This is not a badassumption for the case weare most interested in— prisons. In situations where ownership is separated fromcontrol, some of the trade-offs that we have identiŽ ed are still likely to be relevant.In particular,theowners and managers of aprivateŽ rm willstill have anexcessive tendency to reduce costs, since they can collectively divide the gains THE PROPERSCOPE OFGOVERNMENT 1143

Finally,weconsiderthe cost/ quality comparisonbetween pri- vateand public ownership:

PROPOSITION 5. Costs (C0 2 c(e))arealways lowerunder private

ownership.Quality ( B0 2 b(e) 1 b (i))maybe higher or lower underprivate ownership. We know that e is higherunder private ownershipthan un- derpublic ownership( eM . e* . eG )and hencecosts are always lowerunder private ownership.Quality maybe higher or lower , sincealthough e is higher,sois i.Onecase where quality is higherunder private ownershipis when b9 (e)issmall(more pre- cisely,wereplace b(e) by u b(e) and let u ® 0); thenquality is deter- minedby differencesin i and notdifferences in e.On theother hand, if b 9 (i)is small,quality is higherunder public ownership; in this casequality is determinedby differencesin e rather than differencesin i. Proposition5 explains what webelieve to be the basic styl- ized facts, namelythat private contractingtypically yields greatercost efŽ ciency ,but thereis ambiguity aboutquality .We couldnot get ambiguity if wehad asimplermodel, in whichthere was noinvestment in quality improvement.In that model,there would bea straight trade-off betweenquality and cost,with public provisiondelivering more quality at ahighercost. That model(i.e., one without b )would resemblethe comprehensive contractingtreatment of Laffont and Tirole{1993, Chapter 4}, whoargue that higherpowered incentives (which mightbe asso- ciated with private ownership)lead toboth lower costs and qual- ity.Ourmodel, in contrast,explains why in some—arguably most—casesprivate provisionleads toboth lower costs and higherquality . B.Competition Perhapsthe single most important issue that ourmodel does notdeal with is expost competitionbetween the suppliers ofthe good.T otakethe simplest case, suppose that consumersbuy the fromcost reduction among themselves, ignoring the adverse quality impact on society.Theimplications for quality innovation are more complicated. T otheex- tentthat the manager of aprivateŽ rm islessreplaceable than the manager of a publicŽ rm (becausethe private company’ s shareholdersare dispersed, say), the privatecompany manager’ s incentivesto innovate will be greaterthan the public manager’s. However,tothe extent that the manager of a privateŽ rm mustshare thefruits of hisinnovation with both the owner(s) and the government, as opposed tojust the government, the private manager’ s incentivesto innovate will be smaller(on the latter effect, see Laffont and Tirole {1993} and Hart and Moore {1990}). 1144 QUARTERLY JOURNALOF ECONOMICS good,or service, directly from a contractor,without any govern- mentintervention, even in Žnancing.Suppose alsothat consum- erscan assess the quality ontheir own (a goodassumption with mostgoods, a plausible assumptionfor education, and probably thewrong assumption for health). Suppose Žnally that thesup- pliersare perfectly competitive at everyquality level.In this case,a private contractorwould faceexactly socially optimal in- centives,since, on the margin, he getsa lowerprice for any qual- ity shortfall resultingfrom a costreduction, and ahigherprice for any quality improvementthrough innovation (that is,he receives 2 b(e) 1 c(e) 1 b (i)). Privatesupply in this casedelivers the Ž rst- best.On theother hand, apublic managerneeds to negotiate any innovationwith thegovernment, and mightbe replaceable,so his incentivesto innovate are stunted. In this extremecase —where thereis noneed for the government at all—the private sector deliversthe Ž rst-best,and public provisionis inefŽcient. Of course,in mostinteresting cases, the situation is more complicated,and somegovernment role is needed,at leastin Ž- nancing.For example, in educationmost arrangements would allow forthe government to pay forthe service of at leastsome consumers(e.g., through vouchers). The idea is that thegovern- mentneeds to participate in theŽ nancingof these services to reducethe inequality ofconsumption across consumers. As long as consumerscan assess quality and havea choiceamong com- petitivesuppliers, however,private suppliers would still pay for deteriorationin quality resultingfrom cost reduction because the consumerscan goelsewhere. Even in thecase of government Ž - nancing,competition strengthens the case for contracting out. Theobjections to private, competitive supply typically focus onmoresubtle distributional issues,related to inefŽ cient sorting ofconsumers.We discuss theseobjections in SectionV in thecon- textof healthcare and education. 13 C.AlternativeViews ofGovernment:Corruption and Patronage In this subsectionwe relaxthe assumption that thebureau- crat/politician acts onbehalf ofsociety and allowfor him to be self-interested.This self-interest can express itself in anumber

13.Another kind of competition may also be important. Suppose that con- sumerscannot buy from contractors directly ,i.e.,the government must buy on theirbehalf, but there are many (similar) contractors. Then, if one contractor does abadjob, the government can always switch toanother .Such switchingis pos- siblewhether contractors are private or public. Thus, it is notimmediately clear thatcompetition of thissort makes private provision more attractive. THE PROPERSCOPE OFGOVERNMENT 1145 ofways. First, the politician maybe corrupt, in thesense of being willing touse his controlrights to extract money (or campaign contributions)for himself from the contractor. Second, the politi- cian mayuse his controlrights to pursue political objectivesother than thepublic interest,such as cateringto interest groups that mightsupport himin theelection. These alternative character- izations ofpolitical behaviormatter for the choice of the optimal deliverymode. Toillustratethese issues, we describe two simple —but possi- bly important—cases. In oneof them, corruption leads toan ex- cessivetendency to privatize. In theother ,patronageleads to excessivein-house provision. Suppose that theprivatization decisionis madeby ahigher 1 levelpolitician at somedate 2 2 beforedate 0(seeFigure I). Sup- posealso that thepolitician is notinvolved in F’soperationsafter theprivatization decision;that is,contracting decisions pass toa bureaucratwho is assumedto be honest. In contrast,the politi- cian takesmonetary bribes. Underthese conditions the politician has asimplechoice. He canprivatize F (a prison)—in whichcase he arranges to sell it to aprivate companyowned by M (thefuture owner-manager of F). Suppose that thepolitician canset the price artiŽ cially lowand extracta bribefrom M;i.e.,the politician canavoid selling F throughcompetitive bidding. Alternatively,thepolitician can keep F public and appoint M as thefuture manager (the warden). In this situationwe suppose that thepolitician canextract a bribe from M in returnfor M’sfuturebeneŽ ts as manager. Underreasonable assumptions the politician canextract a higherbribe if heprivatizes F than if hedoes not. If thepolitician privatizes F,thenat date 0, M is in abilateral bargaining position with thebureaucrat G concerningthe terms of thecontract. The totalsurplus tobe divided is givenfrom (9) by SM. Under the 1 assumptionof Nash bargaining, Mreceives 2SM through the 1 price P0.Nowmove back to date 2 2.At this date,as longas thereare many potential (identical) Žrmsand managerswho can runthe prison, the politician canoffer to sell F towhoever pays 1 thehighest bribe: the highest bribe is ofcourse 2SM and so this is thepolitician’ s payoff. Nowconsider the case where the politician keeps F public. Howmuch would M pay forthe privilege of being the warden? The problem M facesis that,prior to a contractwith G being written,he has nojob security; i.e., if theprison is public, there is nothingto stop thebureaucrat from replacing M with another 1146 QUARTERLY JOURNALOF ECONOMICS managerat date 0(norelationship-speciŽ c investmentshave yet beenmade). Hence M’sfuturepayoff is zero,which means that this is alsothe politician’ s bribe!The conclusion is that thecor- rupt politician always wants toprivatize F evenif this is so- cially inefŽcient. An equally importantconsideration ignored by assuming that politicians act in thepublic interestis that politicians often caterto special interestgroups, such as laborunions, to win elec- tions{Stigler 1971; Becker1983}. Politiciansmay choose to use public moneyto provide jobs for the workers who then favor them in theelections, or to pay suchworkers wages above market levels.If spending public resourcesto transfer wealth to such interestgroups is easierwith in-houseprovision than with con- tracting,then politicians would havea bias toward toolittle pri- vatization {Shleiferand Vishny 1994}. Patronagethus has the oppositeeffect to corruption: it leads toan excessivebias toward in-houseprovision. Interestingly ,excessiveemployment in public Žrmsmay lead toexcessively high quality (if having morepeople increasesquality). Forexample, the quality ofservice in some Europeanstate airlines, such as Air Franceand Lufthansa,may beexcessively high, and apossibly lowerquality at private air- linesis noevidenceof lowerefŽ ciency . Avoiding excessivepublic spending onpolitically powerfulin- terestgroups is indeed oneof the principal goalsof privatization throughoutthe world. In theUnited States, public sectorunions area powerfulspecial interestgroup that has deliveredsome of themost vocal opposition to government contracting, including privatization ofprisons{AFSCME 1985}. Someevidence suggests that thepresence of strong public sectorunions, as wellas soft budget constraintsof the government, are important obstacles to privatization oflocal government services in theUnited States {Lopez-de-Silanes, Shleifer,and Vishny 1997}. Positiveconsiderations thus suggest an importanttrade-off betweenprivatization and in-houseprovision. T otheextent that corruptionis aseriousproblem, the case for privatization is weakerthan it is underbenevolent government. 14 But tothe ex-

14.A similarset of issuesarises when the politician is lazyor unmotivated. Such apolitician,like his corrupt counterpart,may write bad contracts thatfail toprotect thepublic, award contracts toinefŽ cient suppliers, pay excessiveprices, failto supervise contractors, fail to enforce important contractual provisions, etc. Becauseprivatization locks the government into these bad arrangements, lazi- nessof politicians,like corruption, tends to point against privatization. THE PROPERSCOPE OFGOVERNMENT 1147 tentthat political patronageis asevereproblem, the case for pri- vatization is stronger.Areformerconsidering privatization must havea clearidea astowhether corruption or patronage is abig- gerproblem in his polity.

IV. PRIVATIZATIONOF PRISONS A. Overview Privatizationof prisons refers to the contracting out by the governmentof the operations of prisons to private companies.In themiddle ages,prisons were typically private,but by thetwenti- ethcentury ,governmentsin mostcountries had takenover their operation.In theUnited States today,whileprivate companies by law arerestricted from meting out punishment, and public employeesare usually presenteven in private prisonsto make decisionson issues that canbe interpreted as changesin these- verityof prisoners’ punishment, almost all theother activities re- lated toincarceration can in principle beprivatized. Private prisonshave grown rapidly in theUnited States in thelast de- cadefrom a capacity ofabout 1200 prisonersin 1985 toalmost 50,000 prisonersat theend of 1994 {Thomas1995}. Still, private prisonshouse only about 3 percentof thetotal prison population. Despitetheir quantitative insigniŽcance, private prisonshave stimulated anextensivedebate on the cost and quality aspects of private incarceration(e.g., AFSCME {1985}; Donahue{1988, 1989}; Logan{1990, 1992}; Shichor{1995}; and others).Although thereare no largesample studies ofeithercost or quality compari- sonsof public and private prisons,the available literatureis in- formativeenough for us to assess the relevance of theincomplete contractingapproach tothe study ofprisonprivatization. Privateprisons are perhaps 10 percentcheaper, per prisoner , than public prisons. 15 Themajor reason for the lower costs ap- pears tobe the roughly 15 percentwage premium for public guards overprivate guards {Donahue1988}. Partof thelabor cost differenceis that private contractorsdo not pay thepublic union wagepremium; another part isthat theyhire lower quality work-

15.The comparisons are often disputed by critics ofprison privatization, sinceprivate prisons apparently get somewhat less violent prisoners {Donahue 1988;Shichor 1995}, and since some of the costs of private incarceration— such asthe continued need for public oversight— are often ignored in thecomparison. On theother hand, some of the costs of public prisons, such as forgone tax reve- nuesand often even capital costs, are also often ignored in the comparisons. 1148 QUARTERLY JOURNALOF ECONOMICS ers.Since labor accounts for two-thirds oftheincarceration costs, thedifferences in laborcosts can roughly account for the 10 per- centcost saving fromprivate prisons. Themost controversial and interestingissues raised by pri- vateprisons concern the quality ofservice. Quality coversorder in theprisons (security of prisoners,escapes, staff conducttoward prisoners,violence by guards and betweenprisoners, disciplinary procedures,etc.), amenities that prisonersreceive (quality of food,health care, dental care,mental care, clothes, quality of facilities,prison work, entertainment, access to legal help, etc.), and rehabilitation(vocational training, other education, parole procedures,etc.). Objections to prison privatization typically fo- cuson quality .ToquoteDiIulio {1987}, “Thehistory of private sectorinvolvement in correctionsis unrelievedlybleak, a well- documentedtale of inmate abuse and political corruption.In manyinstances, private contractorsworked inmates to death, beat orkilled them for minor rule infractions, or failed topro- vide inmateswith thequantity and quality oflife’ s necessities (food,clothing, shelter ,etc.)speciŽ ed intheiroften meticulously- drafted contracts.”This account is notextreme among those by criticsof private prisons,such as Webband Webb{1963} and Shi- chor{1995, Chapter 2}. On theother hand, Logan{1992} reports theresults of a surveyof three women’ s prisonsin NewMexico that point tosuperior quality ofthe private prison.The central questionof prison privatization is whetherthe poor history is a goodguide to the present and thefuture. Ourtheoretical analysis helps organizesome of thethinking aboutprison privatization aroundthe questions of what contracts canand doaccomplish. Accordingly ,weshow Ž rstthat manyof thequality problemsin incarcerationcan actually beaddressed throughcontracts. Nonetheless, we also show that seriousand unavoidable incompletenessremains even in the“ bestpractice” existingcontracts. Moreover, the incompleteness takes the form describedin themodel: contractors have an opportunityto reduce costsin ways that maylead toa substantial deteriorationof qual- ity.Wealso address thehighly pertinentproblems of corruption and poorenforcement of contracts. We conclude by applying the modelto thechoice of prisonprivatization. B.What ContractsCan Accomplish Toassessthe possibilities ofcontracting,we examinemodern “bestpractice” in theUnited States. One measure of bestpractice THE PROPERSCOPE OFGOVERNMENT 1149 is accreditationby theAmerican Correctional Association, a pseudo-public body that issuesstandards forgood prisons (e.g., ACA {1990}) and accreditsprisons that meetthem. The ACA pro- poses463 standards foradult correctionalinstitutions covering suchmatters as administration and managementof prisons (including personnelpolicies, staff training and development, bookkeeping,Ž scal management,etc.), physical plant (including building and safety codes,security ,inmatehousing, prison size, etc.),operations (including rulesand discipline, securityproce- dures,inmate rights, special conŽnement, etc.), services (includ- ing inmateclassiŽ cation, food, hygiene, health care, social services,etc.), and inmateprograms (work, education, recreation, mail,visiting, library ,religion,etc.). Of thesestandards, 38 are mandatoryand covertraining and staff development,building and safety codes,security and control,safety and emergencypro- cedures,inmate rights, classiŽ cation, food service, sanitation and hygiene,health care, and workin correctionalindustries. T oget ACA accreditation,which is renewedevery three years, an insti- tutionmust meet all 38 mandatorystandards and 90 percentof thenonmandatory standards. In general,only a smallpercentage ofeither public orprivate prisonsget ACA accreditation.How- ever,even if aprivate prisondoes not get ACA accreditation,a prisoncontract can use some or many ACA standards as con- tractprovisions. ACA standards tend tobe process rather than outcomeori- ented.They typically insist that afacility havea writtenset of rulesor apolicymanual dealing with speciŽc matters,as wellas staff toattend tothese matters. ACA standards usually donot specify thecontent of these rules. Presumably ,amanual helps train prisonstaff, as wellas enablinginmates to complain (or sue)if thewritten rules are violated— something they could not dowithout a manualto point to.On somematters, such as food and health,ACA actually doesspecify minimumquality stan- dards that would berelatively difŽ cult to get around. On food, ACA speciŽes the number of meals that mustbe served, caloric intake,time between meals, conditions for preparation and keep- ing offood,as wellas palatability.It alsorefers to thestandards ofthe American Dietetic Association on food quality .A1990 con- tractbetween the Corrections Corporation of America (CCA) and theMetropolitan Government of Nashvilleand Davidson County, Tennessee,illustrates the role that ACA standards canplay in contracting.This contract covers the construction and threeyears 1150 QUARTERLY JOURNALOF ECONOMICS ofoperation of a prisonby CCA, tobe compensated by aŽxed constructionfee plus aper-diemrate for prisoners. The contract speciŽes that CCA mustachieve accreditation of the prison by the ACA within twoyears of the service commencement day ,and moregenerally relies on ACA standards, particularly in themat- tersof amenities and service.The contract also speciŽ es that threegovernment employees must be permanently present at the premises,including theContract Monitor, in orderto monitor contractperformance as wellas reviewdisciplinary and appeals reports.A reading ofthis contractsuggests that, if bestpractice is followed,many aspects ofthe quality ofincarceration can be addressed throughcontracting.

C.ContractualIncompleteness Althoughcontracts can address somequality issues,in sev- eralimportant areas incompleteness is evident,and couldin principle compromisethe quality ofservice delivered by aprivate contractor.The two crucial areas we consider are use of forceand quality ofpersonnel. These areas have been the focus of much of thecriticisms of private prisons(e.g., Shichor {1995}). Themandatory ACA standard ontheuse of forceis notespe- cially detailed:“ Writtenpolicy ,procedure,and practicerestrict theuse of physical forceto instances of justiŽ able self-defense, protectionof others,protection of property,and preventionof es- capes,and thenonly as alast resortand in accordancewith ap- propriatestatutory authority .In noevent is physical force justiŽable as punishment.A writtenreport is prepared following all usesof force and is submittedto administrative staff forre- view.”Aseparate,but equally vague,mandatory standard gov- ernsthe use of Žrearms.The T ennesseecontract allows theuse of deadly forceto prevent escapes, and ofnondeadly forceto enforce institutional regulationsand orders,which is aweakrestriction indeed. In thearea of the quality ofpersonnel, the ACA (non- mandatory) standards requirethat aprocedurebe used to deter- minestafŽ ng needs, and that thevacancy rate be kept under 10 percentfor any eighteen-monthperiod. Correctional ofŽ cers are alsorequired to receive 120 hoursof training in theirŽ rstyear, and 40 hoursin subsequentyears. Little is said aboutthe quality ofthe training (exceptfor topics covered) or the quality ofthe ofŽcers. The T ennesseecontract follows the ACA ontraining,but THE PROPERSCOPE OFGOVERNMENT 1151 alsospeciŽ es that “at thetime the facility opensand during the Žrstyear of thecontract, a minimumof 25 percentof contractor’s securityemployees will haveat leastone year of correctionssecu- rityexperience. Davidson Countyresidents will begiven a hiring preferencein stafŽng the facility .”What is mostinteresting about thesestandards is howfew thereare, and howmuch discretion thecontractor has in saving costson personnel. Doescontractual incompleteness lead tothe deterioration of quality? Unfortunately,nosystematic evidence is available on this matter.Wecan get a glimpseof theissues by lookingat two (verysmall sample) reports.The Ž rstis acomparativeevaluation oftwo public prisonsand oneprivate (CCA-managed) prisonin Tennessee,done by that state’s government{State ofT ennessee 1995}. Althoughthis evaluationhas concludedthat all threepris- onsare overall of extremely high quality ,with theimplication that acheaperprivate prisonis agooddeal forthe state (see also TheNew Y orkT imes {September19, 1995}), it is clearfrom the body ofthe report that thelevel of violence is higherin thepri- vateprison: “ Thenumber of injuries to staff and prisonersis a measureof the security and safety ofthe facility .Duringthe Ž f- teenmonth period, the private prisonreported signiŽ cantly more (214) injuriesto prisoners and staff, comparedto 21 and 51 for thetwo state prisons, respectively .Theprivate prisonalso re- ported30 incidentsof the use of force, compared to 4 and 6,re- spectively,forthe state prisons.” The T ennesseereport minimizes this evidencebecause of the possible differences in reporting practices,but it is suggestivenonetheless. WhileCCA private prisonsin Tennesseeare widely regarded as asuccessof private prisonmanagement, ESMOR’ s detention facility in Elizabeth, NewJersey ,operatedfor the Immigration and Naturalization Service(INS), is widely regardedas afailure, in part becausea riotbroke out at that facility onJune18, 1995. TheESMOR facility housedforeign nationals whowere caught attemptingto enterthe United States illegally throughKennedy and Newarkairports, and whowere awaiting deportation—not exactlya hard corecriminal crowd. ESMOR wonthe INS contract by signiŽcantly underbidding anotherprivate competitor,in part becauseit assumedin its bid lowerwage rates for prison staff. Thecontract actually speciŽed thetypes ofworkersthat ESMOR was supposed tohire, but it turnedout to be possible within the contractto hire as guards individuals whopreviously guarded 1152 QUARTERLY JOURNALOF ECONOMICS goodsin warehouses.With respect to training,ESMOR evidently justviolated the contract: the INS reportsthat ESMOR “did not meetrequirements of thecontract” in this area. Overall,the ESMOR facility was seriouslyunderstaffed, guards did notreceive enough training, guards wereimplicated in incidentsof physical abuseof prisoners, and supervisionof staff by managementwas lacking.When the riot broke out, the guards immediatelyran away ,and called thepolice from a pay phone.INS attributed manyof the problems at thefacility to ESMOR’s cuttingcorners, principally onlabor .Theevidence in thereport points tothe possibility ofcost savings by private con- tractorsat theexpense of quality,aswellas tothe government’ s failureto respond to explicit contractviolations by thecontractor (seefootnote 14). In sum,while systematic evidence on thequality ofincarcer- ationby private and public prisonsis notavailable, theexisting shredsof evidence suggest that in importantdimensions, such as prisonviolence and thequality ofpersonnel,prison contracts are seriouslyincomplete. This incompleteness can, and sometimes does,give rise to quality shortfalls in private contracting.

D.What DoesOur Model Say about Prison Privatization? Prisonsseem to Ž treasonablywell into our framework. Al- thoughin somerespects prison contracts are very detailed, they arestill seriouslyincomplete. There are signiŽ cant opportunities forcost reduction that donot violate the contracts, but that,at leastin principle,can substantially reducequality .Moreover, fromthe available evidencewe have the impression that the worldmay not be far fromthe assumptions of Proposition 4. First,the welfare consequences of quality deteriorationmight be ofthe same magnitude as thoseof cost reduction ( b(e) and c(e) arecomparable). Second, the opportunities for quality innovation arelimited ( b (i)is small).Under these conditions, Proposition 4 suggeststhat public ownershipis superior. Wouldex post competitionbetween prisons for inmates strengthenthe case for privatization? Onepossibility is that con- victsthemselves choose the prison in whichto serve their senten- ces,but this is probably abad idea,since prisoner choice would encouragecontractors to attract customersby allowing gangs, drugs,and perhaps eveneasy escapes. A moreplausible alterna- tiveis tohavejudges choose a private prisonto send a convictto, THE PROPERSCOPE OFGOVERNMENT 1153 with theidea that judgeswould sendmore inmates to higher quality prisonsand fewerto lower quality prisons.Private con- tractorswould thenhave the appropriate incentivesto invest in quality improvements,and toavoid excessivecost reductions, to bring in morebusiness. At themoment, such schemes have not beentried, in part becausethere is ashortageof prison capacity in theUnited States, but it is possiblethat theycould be tried in thefuture. One potential disadvantage ofsuch judge choice is that somejudges might actually chooselower quality prisonsbe- causethey want theinmates to get a stiffer penalty,whereas otherjudges might choose prisons that aresoft on inmates.Con- tractorswould thencater to the preferences of the judges, which neednot coincide with socialwelfare. Finally,thechoice of whetherto privatize prisonsdepends on theimportance of corruption and patronage.Patronage does not appear tobe a hugeproblem in prisonemployment in theUnited States,since the union premium as ofthis writing is notlarge. Corruptionappears tobe a greaterconcern, at leastjudging from theavailable anecdotalevidence. T obegin,private prisoncompa- niesare very active politically .Forinstance, ESMOR evidently lobbiespoliticians and makespolitical contributionsto receive contracts {TheNew Y orkTimes, July 23, 1995}. Thewife ofT en- nesseegovernor Lamar Alexander invested early and proŽtably in thestock of CorrectionsCorporation of America,which subse- quentlygot involved very deeply in theprivatization ofT ennessee prisonswith thegovernor ’sendorsement{ TheNew Republic, March 4,1996, p. 9}. Arelatedproblem is that contractenforcement cannot be takenfor granted. The INS reportconcludes that ESMOR’s changesin policies“ hinderedINS ability toeffectively perform its oversightfunctions.” The report also notes that ESMOR told its guards notto share information with theINS ofŽcials working onthe premises, and in oneinstance encouraged the INS toreas- sign an ofŽcer who complained about the performance of theEliza- beth,New Jersey ,facility severalmonths prior to the riot. The reportindicates that ESMOR violatedthe contract in somein- stances,and alsopursued policiespreventing the INS fromen- forcingthe contract. But it is alsoclear from the report that the INS did notdo what it couldto enforce this contract.The INS reportvividly illustrateshow a governmentbureaucracy with rela- tivelyweak incentives has troubleenforcing a contractwith apri- 1154 QUARTERLY JOURNALOF ECONOMICS vatesupplier determinedto reduce its costs,even if this involves violationsof the contract and notjust the issues on which the contractis silent. In sum,our model suggests that aplausible theoreticalcase canbe made against prisonprivatization. Thiscase is weakened if competitionfor inmates can be made effective, but strength- enedby therelevance of political activismby private contractors. Oneinstance in whichthe case against prisonprivatization is strongeris maximumsecurity prisons, where the prevention of violenceby prisonersagainst guards and otherprisoners is acru- cial goal {TheNew Y orkT imesMagazine 1995}. In manycases, theprincipal strategyfor preventing such violence is thethreat oftheuse of force by theguards. Wehave shown that it is difŽcult todelineate contractually the permissible circumstances for the useof suchforce. Moreover, hiring less educated guards and un- dertrainingthem —whichprivate prisonshave a strongincentive todo —canencourage the unwarranted useof forceby theguards. As aresult,our arguments suggest that maximumsecurity pris- onsshould notbe privatized solong as limitingthe use of force against prisonersis an importantpublic objective.Consis- tentwith this view,only4 ofthe 88 private prisonsin Thomas’s {1995} censusof private adult correctionalinstitutions in the UnitedStates aremaximum security .In contrast,private half- way housesand youthcorrectional facilities, where violence prob- lemsare less serious, are common {Shichor 1995}.

V. OTHER ACTIVITIES In someways, our model was constructedto Ž tprisons.How- ever,it canhelp analyze otheractivities as well,as weshow in this section.We also examine some of the model’ s limitations. A.StraightforwardCases: Garbage Collectionand Weapons Procurement In thecase of garbage collection, the damage to quality re- sulting fromthe private contractorhiring inferior employees or failing tomaintain theequipment is probably trivial ( b(e) is low). Ouranalysis thenimplies that private provisionis superior.This resultobtains eventhough in garbagecollection ex post competi- tionis extremelyexpensive, since it is essentialthat thesame companypick up garbagefrom neighboring houses {Donahue THE PROPERSCOPE OFGOVERNMENT 1155

1989}.Thesuperiority of private provisionin garbagecollection is documentedby severalempirical studies {Donahue1989}. Weaponsprocurement is anothercase where our model points tothe superiority of private provision.Although the dam- ageto quality fromcost reduction might be signiŽ cant, to a large extentthis problemcan be dealt with contractuallythrough therequirement that weaponsmeet well-speciŽ ed performance requirements.Moreover, quality innovationis enormouslyimpor- tant in weaponsdesign, and theincentives of private suppliers areprobably strongerthan thoseof public employees.As aconse- quence, if b(e)canbe limited through contracts, Proposition 3 points tothe superiority of private ownership.

B.ForeignPolicy In manysituations the nature of theservice that thegovern- mentwants tobe performed is extremelycomplex and unpredict- able,so any contractis inherentlyextremely incomplete. Most actual decisionsof the contractor have to be renegotiated at the government’s initiative,which exposes the government to the highcosts of paying up tothe contractor who has alotof power. Forexample, as Wilson{1989} shows,it is virtually impossibleto describein advance what servicesneed to be performed to carry outAmerican foreign policy ,atask nowassigned tothe State De- partment.Suppose that theState Department were to be privat- ized,and asetof policies toward different countriesspeciŽ ed in thecontract. In this case,when the government wants tochange its policytoward acountry(say becauseRussia renouncescom- munism),it would haveto persuade the private contractorto changewhat it does.In this renegotiationthe government pre- sumably would haveto pay theprivate contractormore than it would pay an employee,who is totally replaceablewhen few ex anteinvestments are involved. In-house provision in this caseof fewinvestments and enormousex post holdup opportunities seemsclearly superior. Askepticcan respondto this analysis by suggestingthat per- haps, exante,the government should auctionoff theforeign pol- icycontract for a vast amountof money with an understanding that it is goingto be regularly held up expost. What is wrong with this arrangement?In ourtheory we have assumed that M is wealthyenough to pay up frontfor the right to own F when private ownershipis optimal.However ,in somecases, such as 1156 QUARTERLY JOURNALOF ECONOMICS theconduct of foreign policy , M maynot be wealthy enough. This createsa furtherargument for public ownershipwhen M’s ex post hold-up powervastly exceedsthe amount he can raise ex antefor the contract. If M cannotcompensate G in advance for all thefuture holdups when G changesthe contract, then the ex- tractionof surplus from G by M is sociallywasteful. Hence the governmentmay wish toown F simply toavoid having tocompen- sate M whenit changesits mind at date 1. 16 Thislogic conŽ rms theconclusion that foreignpolicy should beconducted by govern- mentbureaucrats.

C. Schools An importantexample that goesoutside of our basic model is theprovision of schooling. For schools, the damage to quality fromcost cutting, b(e),maybe large, but innovationis probably important,and theincentives of publicly employedteachers, es- pecially whenthey are protected by unions,are weak. Our propo- sitions,therefore, do not give a clearanswer as towhich ar- rangementis superior.The key aspect ofschools,however ,is the potentialfor ex post competition.In voucherarrangements com- bined with schoolchoice, the government pays foreach child’ s education,but childrenand parents selectschools. We conjecture that thecase for such private arrangementsis extremelystrong. Schoolchoice would forceprivate schoolsto compete for students by providing higherquality ,sinceschools cannot compete in price whenstudents pay with vouchers.This competition should sig- niŽcantly reducethe incentive to cut quality whilecutting costs, as wellas increasethe incentive to innovate quality .Indeed,the available evidencesuggests that competitionbetween schools is associatedwith ahigherquality ofeducation{Hoxby 1994}. Critics ofvouchersand schoolchoice often point toa particu- lar aspect ofquality that theybelieve would fall as aresultof privatization, namelyreduction of access of some students to goodeducation. SpeciŽ cally ,criticsfear that sortingof students by ability would increaseas aresultof sucharrangements, which theyregard as sociallyundesirable. Such sorting can take two

16.This argument is developed further inTrinh{1996}. One may ask why M couldnot borrow against the receipts from his future hold-up opportunities. The answeris that a bankmay be unwilling to lend to M,sincethere is nothing to stop M from“ holdingup” the bank by refusingto hold up the government. That is,having received his loan, M canthreaten not to hold up the government at date 1anduse this threat to renegotiate downward hisrepayment to the bank {Hart andMoore 1994}. Anticipating this, the bank will refuse to lend to M. THE PROPERSCOPE OFGOVERNMENT 1157 forms.First, good private schoolspaid with voucherswould select thebest students, leaving the not-as-good students tonot-as-good schools.Second, private schoolswould avoid expensive-to- educatechildren altogether ,whowould thenget stuck in residual governmentprograms. Critics chargethat suchoutcomes are less sociallydesirable than thoseinvolving less sorting. Some school districts havetried to solve these sorting problems contractu- ally by,forexample, using courtsto allocate students toprivate schoolsthat wish tobe paid with vouchers{Moe 1995}. Whether contractscan successfully address theconcerns of the critics of schoolchoice, and whetherthese concerns are actually justiŽed fromthe social welfare viewpoint, are questions requiring fur- therinquiry .

D.HealthCare In thecase of healthcare, as with education,the government wants topay forthe services of at leastsome consumers, and needsto design agoodarrangement for doing so.One aspect of this design is whetherhospitals shouldbe private orpublic. In theanalysis ofoptimal ownership,there are some similarities be- tweenschools and hospitals, as wellas somedifferences. T obe- gin,in healthcare, as in education,gains frominnovation are enormous,but sois thedamage to quality fromcost cutting. Moreover,the distributional aspect ofquality is extremelyimpor- tant in bothservices, namely ,thedanger that expensive-to-treat consumerswould bedenied careif thegovernment pays lessthan it coststo treat them. Onefurther similarity is that expost competitionbetween hospitals—letting patients choosetheir hospital— can play arole in healthcare. Such competition generally strengthens the case forprivatization. However,acrucialdifference is thelimited abil- ity ofconsumersto assess the quality ofhealthcare they receive. Consumersoften cannot tell whether hospitals havefailed topro- vide careto save costs, and hencewould notso readily change suppliers in responseto poor quality .Forthis reason,the combi- nationof private ownershipand competitionwould notbe nearly soeffective in healthcare as in education,making the case for somegovernment ownership stronger . Perhapsbecause of all theseconcerns about private provi- sion,most countries have responded to the need to providehealth careto all theirpeople through government provision. The UnitedStates has beendifferent in relyingon both private and 1158 QUARTERLY JOURNALOF ECONOMICS public hospitals, with thelatter taking careprimarily ofindigent patients.Historically ,private hospitals havebeen paid onacost- plus basis—an approach that ourmodel does not accommodate (sincewe assume that costsare nonveriŽ able) but which,unsur- prisingly,has provedextremely expensive. More recently ,the formof compensating providers has shifted toŽ xedfees for ser- vices,a contractvery similar to that analyzed in ourmodel. Not surprisingly,thesecontracts have increased concerns about qual- ity deterioration,particularly in theso-called HealthMainte- nanceOrganizations. An analysis ofhealthcare would requirea signiŽcant generalizationof our model, especially since veriŽ ca- tionof costsand cost-plus contractshave played an essentialrole in paying forthis service.

E.Policeand ArmedForces ConsiderŽ nally somebasic servicesprovided by thegovern- mentthat nobodyseriously thinks of privatizing: thepolice and thearmed forces. Our framework helps toexplain why theseser- vicesshould notbe privatized. If thepolice or armed forces were privatized, theowners of theresulting private companieswould haveenormous power. Partof this powerwould stemfrom the direct ownership of weap- onsthat arecurrently in public hands. Theowners could use this powerto hold up thegovernment and society.Forexample, sup- poseas an extremecase that nuclearweapons were sold off toa private companyand an (incomplete)contract was writtenwith thecompany as tohow these weapons should beused in theevent that thecountry is threatenedwith attack.The concern is obvi- ouslythat theprivate companywould wriggleout of the incom- pletecontract and eitherthreaten to withhold theweapons in the eventof an emergencyto extract a hugeside-payment from thegovernment, or eventhreaten to use the weapons against the countryitself unlessit receivessuch a side-payment. Westress that keepingthe nuclear stockpiles —orarmed forces—public doesnot eliminate the possibility ofattempted holdup. Ageneralwho is astateemployee could use his accessto nuclearweapons to attempt to hold up society.After all,coups and rebellionsby thearmed forces do sometimes occur .However, thereis adifferencebetween the private and public cases.If nu- clearweapons or the armed forces are publicly controlled,the governmentcan take early action to prevent a potentialholdup. If it suspectsthat an errantgeneral is engagedin treason,it can THE PROPERSCOPE OFGOVERNMENT 1159

Žrethe general. In contrast,in theprivate case,the government would haveto wait until aclearbreach of contractoccurred; this mightbe too late.

VI. CONCLUSION Wehave examined the conditions that determinethe relative efŽciency of in-house provision versus outside contracting of gov- ernmentservices. Our theoretical arguments suggest that the casefor in-house provision is generallystronger when non- contractiblecost reductions have large deleterious effects on quality,whenquality innovationsare unimportant, and when corruptionin governmentprocurement is asevereproblem. In contrast,the case for privatization is strongerwhen quality- reducingcost reductions can be controlled through contract or competition,when quality innovationsare important, and when patronageand powerfulunions are a severeproblem inside the government. Wethen applied this analysis toseveral government activi- tiesusing theavailable evidenceon the importance of vari- ousfactors. We concluded that thecase for in-house provision is verystrong in suchservices as theconduct of foreign policy and maintenanceof police and armedforces, but canalso be made reasonablypersuasively for prisons. In contrast,the case for pri- vatization is strongin suchactivities as garbagecollection and weaponsproduction, but canalso be made reasonably persua- sivelyfor schools. In someother services, such as provisionof healthcare, an analysis ofthe efŽ ciency of alternative arrange- mentsis agreatdeal morecomplicated and requiresa muchmore detailed modelof competition, contracts, and regulationthan we couldprovide in this paper.Wedefer such analysis tofuture work.

HARVARD UNIVERSITY HARVARD UNIVERSITY UNIVERSITYOF CHICAGO

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