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Chapter Summary

Sclar, Elliot 2000. All in the System: Organizational Theories and Public Contracting, Chapter 5 of You Dont Always Get What You Pay For: The Economics of Privatization. Ithaca, NY: Cornell University Press.

In the fifth chapter, Elliot Sclar argues that given the ideological and political pressures to privatize, we must examine under what conditions contracting and in what form contracting might be successful. Sclar begins with a critique of the standard economic model, which assumes that actors have equal access to information regarding the contract, a static documented agreement. Sclar argues for a form of relational contracting as an alternative. Sclar bases his arguments in the following theoretical assumptions: 1) a notion of bounded rationality, which concedes the inability of actors to have access to all relevant information, and 2) and the notion that context matters, a concept derived from new institutional economics, which incorporates the institutional constraints of ideology and politics, as well as economic rationality.

Sclar dismisses as unrealistic the classic or complete contract form because it assumes that the terms of the contract can captur[e] all present and future rights and obligations between the parties. Sclar also critiques incomplete contracts, which are more common to public service contracting. He argues that it is nearly impossible to specify all future situations and contingencies in a contract. Furthermore, the notion of incomplete contracts is still rooted in the theoretical assumption of market competition. Incomplete contracting, he demonstrates, produces the following three problems: 1) principal-agent problems; 2) adverse selection; and 3) moral hazards.

Principal-agent problems typically occur when one party (the principal) hires another (the agent) to carry out an assignment, but the agent serves its own interest at the expense of the principal because of information asymmetry (a situation in which existing information is not uniformly distributed therefore those with access to superior information act opportunistically and at the expense of the others). To offset information asymmetry, public agencies or private firms that find themselves less privileged in incomplete contracting situations often hire third-party consultants. This, however, adds extra costs.

Adverse selection refers to a situation in which one party, in this case the public sector, chooses a seemingly attractive provider based on criteria such as the best price. But, because the public administrator does not have complete information regarding the competing bidders the choice results in a mistake. The contractor may turn out to be less qualified and risk-tolerant, to have chronic cash-flow problems and/or high rates of labor turnover. In all of these cases, the price signaled a choice that over the long-term may be more costly than if the administer had been aware of these other factors and criteria.

The problem of moral hazards in public contracting may arise when there is a discrepancy between the public objectives and the incentives of the private provider to meet those objectives.

Sclar argues that in practice any instance of privatization typically includes manifestations of all three problems.

As a way to overcome the pitfalls of traditional contracting situations (i.e., complete and incomplete contracting forms), Sclar suggests relational contracting, which he notes is already practiced in the human services where the government has established long-term relationships with often non-profit third sector providers. Relational contracting is not market-based competition but in inter-organizational trust aimed at building long-term relationships and capacity. Sclar invokes terms, such as bilateral governance, networked governance and hybrid organizations (123). In relational contracting, the formal contract or agreement is less critical than the quality of trust that develops between the parties.

Sclar further argues that relational contracting offers a basis for improving both the internal workings of public agencies and their external relationships. This contracting form, in the authors view, also avoids high transaction costs (time and resources spent obtaining the information necessary to chose among competitors and to ensure that terms of the contract are comprehensive), by supplanting them with trust and cooperative long-term relationship (i.e. a stable network). Such cooperative long-term relationships, Sclar, are both constrained and supported by the formal and informal social, political and economic rules in which they are embedded.