This article presents arguments against privatization and the contracting of public services. Three case studies are used to portray the deficiencies of contracting along with a discussion of some general economic principles that support case findings. Sclar concludes that monitoring and contract transaction costs more than outweigh the benefits of privatization in the cases he examined.

Spot vs. Contract Markets

For Sclar, contracting government services is likely to result in cost savings when the price of the service is determined in a "spot market." A spot market is similar to the economic abstraction of a perfectly competitive market: the price of a good or service is kept low because there are many producers of the same or similar products. Thus, competition maintains downward pressure on prices.

Contract markets are different because there are generally few producers of the good or service. This not only leads to difficulties in determining prices but the product itself is not easily quantified. In this market a decision to contract involves:

• specification of the product
• negotiation of prices
• close monitoring of quality
• anticipation of contingencies
• an assessment of the typical production costs
• a determination of the transaction costs of contract design and monitoring

Transaction costs are often underestimated or neglected all together. Governments ignore the transaction and monitoring costs when they treat the goods and services that have contract market characteristics as if they were suitable for purchase in the spot market.

Moral Hazard

In terms of private goods, consumers have an economic incentive to protect their investments. Sclar suggests that this is not the case when considering public goods, especially those with contract market characteristics. Public contracting, by contrast, always involves "moral hazard," which arises in any situation in which the best economic interest of at least one of the parties to a transaction can be better served by dereliction of duty or outright dishonesty.

In order to establish accountability, governments need to create bureaucracies and audit systems for their contracts. These are the transaction and monitoring costs that are often ignored.

Three Case Studies

These cases were selected based on two criteria. First, each case had to have been in existence long enough to rule out problems associated with startup difficulties. Second, a significant amount of material in the form of public documents, newspaper accounts, and interviews could be gathered to provide an adequate reflection of the cases being examined. These cases were considered good candidates for privatization because the "blue collar" nature of the work involved made it easy to administer via private contractor. In addition, the services being conducted are typical of those found in spot markets.

The Albany Department of Public Works

The Albany case study reveals the impact of transaction costs in a privatization contract. The entire vehicle maintenance operation of the Department of Public Works was contracted out in January of 1992. The premise was to replace the salaried public employees with hourly work at outside garages. The City would then pay only for the time that the vehicles were actually being serviced which was expected to result in between $100,000 and $200,000 in savings. Indeed, in 1995 the City of Albany reported in their budget that they had reduced their costs by 18% during 1994. However, the comptroller's office pointed out that this "savings had occurred because of the aggressive supervision of contractor's bills" which resulted in an increase in contract spending. In addition to the discussion of monitoring costs, Sclar cites testimonials that highlight the extent to which contractors had over billed.

MassHighway

In Massachusetts, highway maintenance was one of the first public services to be contracted out as part of an aggressive campaign to privatize government services. MassHighway distributed its highway maintenance on a 50-50 basis; 50 percent to its own public employees and the remaining 50 percent to outside contractors. In this arrangement, the contractors had an incentive to perform only the work that was most profitable to them because the State obligated the contractors to keep the maintenance costs below the contract price. In addition, much of the work was either done poorly or not at all upon inspection.

Sclar indicates that the public sector employees consistently provided a better service at a lower cost. However, the State of Massachusetts has made it clear that over time and through attrition the unionized employees will be replaced by contract workers.

Indianapolis Fleet Services

The Indianapolis example differs from the two studies above in that it is a case study where privatization did not take place. The decision to privatize Indianapolis' vehicle maintenance operations was successfully challenged by the facility's unionized employees. Instead of contracting out the fleet services, the operations were restructured through collaborative labor/management relations with the effect of reducing costs by eight percent. The restructuring has also led to an improved work environment, fewer employees, and continued service quality.

Lessons from Experience

The case studies discussed above are neither typical nor representative of the entire experience with privatization. They do, however, point out several pitfalls for governments seeking to contract with the private sector. Sclar's point here is that each case must be examined carefully and governments should be wary of adopting privatization as "routine and widespread policy". Below, six of these pitfalls are summarized:

1. Governments should avoid making a decision to privatize based on the experience in the private sector with service delivery. Personal car repair is vastly different from maintaining a fleet of vehicles.
2. Governments should investigate the manner and extent of the bureaucracy required to monitor contracts.
3. A careful assessment of costs and savings should be undertaken. This endeavor is more difficult than it seems and governments should be wary of simplified 'bottomline' comparisons.
4. Some attention should be paid to the nature of the service being considered for privatization. Some services are best provided by the public sector and privatization represents a solution to problems that may be better addressed from within the public sector. Labor and management collaboration is just one example of this point.
5. Again, the nature of the service being privatized is an important consideration. Contracting out services to providers that require highly specialized equipment leaves governments at the mercy of the contractor in future negotiations. This is mainly due to the difficulty a government has in procuring the 'critical assets' necessary to provide the service themselves.
6. Once a contract has been awarded, despite the fact that the process may have been competitive, the market structure for that service may undergo a transformation. The act of bestowing a contract may change the market into a bilateral negotiation between government and the winning bidder, creating an arrangement similar to a monopoly.

Guidelines for Public Contracting

Four factor emerge from the privatization debate that "are crucial in determining whether contracting can provide an economic alternative to improving internal organization". First, the importance of the task to the mission of the agency. The routine nature of the service does not necessarily imply that it will be easy to privatize. Second, the frequency with which transactions occur is not an indication of the ability of the service to be privatized. Third, the more complex the task and the more uncertain the environment the more likely it is that privatization will not produce cost-effective results. Lastly, highly specialized equipment requires highly skilled laborers who will perform their duties regardless of who pays them. Introducing a third-party arrangement creates a layer of management that weakens the ability of governments to control the output.

Conclusion

The Sclar paper details some of the shortcomings of privatization and contracting government services. The three case studies support his contention that contracting results in serious contract abuses and increased costs associated with monitoring and accountability; costs that are often ignored in the privatization negotiations.