Academic journal article Economic Inquiry

Production Costs, Transaction Costs, and Local Government Contractor Choice

Academic journal article Economic Inquiry

Production Costs, Transaction Costs, and Local Government Contractor Choice

Article excerpt


Declining fiscal conditions, increasing service obligations, and public clamor for more effective government have led local governments to examine alternatives to the bureaucratic supply of publicly provided services. The alternative which has received the most attention is contracting. Under this arrangement, services are financed by the local government, but production of the service is contracted to external suppliers. A growing body of work has explored the contracting decision, (1) focusing on the production choice--does a local government providing (i.e., financing) a service produce it internally or externally? The contracting decision, however, has a second part, the contractor choice--given the decision to externally produce a service, does the local government contract with other governments, with nonprofit organizations, or with for-profit firms? (2)

Contracting is expected to yield production cost savings by exploiting scale economies, overcoming input rigidities, and capitalizing on managerial and competition-induced efficiency incentives. The extent to which these production cost savings are achieved depends on the sector of the external producer. At the same time, public accountability requires contracting governments to be concerned with the proper execution of the contracting process to ensure that shirking is minimized. The transaction costs generated by this oversight also vary by the sector of the contractor. Thus the cost of service delivery depends on the sector of the external producer. Understanding the contractor choice from among the three sectors would add insight into the motivations for contracting, and ultimately enable us to more correctly predict the cost and service-quality effects of different external supply alternatives.

This paper explores the determinants of local government contractor choice. In the next section we examine the production and transaction costs associated with organizations from the public, nonprofit and for-profit sectors. We then develop a general model of the contractor choice and empirically test it using data on local government contract arrangements for three health services: hospital, drug and alcohol prevention and treatment, and mental health.


We posit that a local government in selecting the sector with which to contract seeks to maximize its utility by choosing the alternative that minimizes the costs of service delivery. There are two components of service delivery costs: production costs and transaction costs. (3)

Production Costs

Contracting is viewed as a means to overcome scale diseconomies, perverse managerial incentives, and input rigidities which generate a production cost premium for internal production. External production separates the production scale decision from jurisdictional size thus allowing scale economies to be realized. This benefit is provided by external production with any contractor of the appropriate size, and thus scale economies should not (in theory) affect the sector choice. However, the extent to which the contractor exhibits managerial incentives and input flexibility which contribute to production cost savings depends on its organizational form.

Managerial Incentives. The efficiency incentives of managers vary by the form of their organization. In public bureaus, principal-agent problems arise from the informational advantages of the agents (bureaucrats) over their principals (mayor/council) which are perceived to increase public production costs. For example, Niskanen's [1971] notion of public bureaucrats as budget maximizers is predicated on the bureau's knowledge of the actual cost of delivering services and the use of this knowledge to increase their budgets. In addition, the lack of property rights to residuals (the difference between budgets and actual production costs) reduces incentives for bureaucrats to minimize costs. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed


An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.