Explaining Privatization Failure: The Vice of Sweet Carrots and Hard Sticks

“Homo Economicus” refers to a predictive framework where human actions are theorized to be subjective, self-serving, and economically rational. The tongue-in-cheek nomenclature testifies to a common curiosity across scholars trained in economics in the instrumental power of material incentives to motivate human behavior. Given that the main intellectual bodies of thought advocating for the privatization of public service, property right (PR), and public choice (PC) theories spawn from Homo Economicus, it follows that insufficient or misaligned incentives are the lead rationale.

PR theory targets the congenital absence of profits in government. Without residual rewards derived from ownership (e.g., investment returns, tradable stock, managerial bonuses tied to financial performance, etc.), there is little incentive for public agency management to economize or innovate, causing lax oversight, poor productivity, and resource waste (Alchian and Demsetz 1972; De Alessi 1980). Private contracting, when skillfully applied, enables governments to have public services delivered by contract through superiorly incentivized private agents, and reap a monetary benefit from the efficiency gains.

PC theory emphasizes the lack of constraints on elected or appointed government officials. The core idea is that democracy is imperfect due to a combination of public ignorance regarding the fine details of governance and the disproportionate influence of embedded interest groups (Niskanen 1971; Tullock 1965; Wolf 1993). Democratic mechanisms for curbing selfish tendencies within publicly financed bureaus are weak, enabling politicians, agency managers, and even lay workers, that is, “bureaucrats,” to engage in self-interested behavior that is contrary to public welfare (Niskanen 1975). Career public officials are theoretically motivated to secure power, whereas public-sector labor unions are theoretically motivated to elect politicians who allow their members to work little for high pay (Buchanan 1977; Buchanan and Tullock 1977). For PC, private contracting breaks the conspiracy between elected leaders and organized employees by separating the public policy role of governance (i.e., authority to decide the scope and breadth of public services) from service production. Collusion tendencies between elected leaders and public employees are severed and the spoil system ends.

Together, PR-PC theories throw a one-two punch at governmental operations. Socialized provision fails due to (1) insufficient internal economic incentives to perform well, and (2) insufficient external political penalties for performing poorly. For both schools, privatization sweetens the carrot and hardens the stick. The carrot, profits motivate frugality and attention to task. Properly administered, public agencies can split a share of the material rewards gained by partnering with efficient private contractors. The stick, privatization interferes with collusion between political leaders, agency management, and organized labor, which redirects attention toward constituent needs, particularly the widespread desire to shrink government. Public officials are pressed to do the public’s will or pay the price on Election Day.

Sweet carrots and hard sticks conform to the notion that efficient behavior can be induced through markets. Multifarious innovations—vouchers, performance pay, social impact bonds, charter schools, the lease of public assets, and so forth, all advanced by New Public Management—have been devised to impose quasimarket pressure on public service provision (Gansler 2006; Lane 2000; Lynn 2006). Managed competition, defined as the periodic use of competitive bidding between multiple potential providers (public and private), is perhaps the most celebrated quasimarket tool. The underlying theory for these innovations traces to PR-PC, although in popular mediums the distilled message is that competitive heat is a positive force for organizational discipline (Hilke 1992; Osborne and Gaebler 1992). Faith in the salutary force of competition is a pillar of neoclassical economic thought (Hayek 1944).

Mainstream economics has long recognized a role for government to resolve two classes of market failure: negative externalities arising from private commerce and the undersupply of goods that impart positive externalities. In a seminal piece, Arrow (1963) explains why healthcare, a good that confers positive externalities, cannot be adequately supplied through private markets alone, laying the theoretical grounds for nonmarket institutional intervention. On the demand side, service complexity and illness uncertainty prevent buyers from fully comprehending and insuring against risks. On the supply side, an ethical code to treat patients regardless of ability to pay coupled with sensitivity toward information asymmetry between physicians and patients induces behavior that is not profit maximizing. Although Arrow proposes insurance subsidies by government, he does not advocate for government provision of care. Arrow’s institutional emphasis is on nongovernmental factors such as corporate charter (e.g., nonprofit over for-profit status), price discrimination by income, and professional norms to bridge gaps in the market (Chernew 2001).

The PR-PC message influenced the field by engendering doubt on the topic of governmental production. Government failure became the rejoinder to market failure. Arguments for leveraging quasimarket mechanisms, led by prominent figures such as Milton Friedman, stimulated interest in expanding the use of private agents to deliver publicly financed goods. These ideas were largely met with conditional acceptance from the academic community. Subsequent treatments did not challenge the logic of using market mechanisms to supply public services but instead toward understanding the boundaries of such tools.

Hart, Shleifer, and Vishny (1997) postulate that socially-beneficial privatization depends on whether a government principal can contractually prevent a private agent from sacrificing quality. In a variant of this theme, Williamson (1999) conditions effective make-versus-buy decisions by government on the size of transaction costs, that is, the price of establishing and enforcing an agreement. Here, a preference for private delivery was assumed due to faith in the superior operational qualities of private firms over government, except where transaction costs were prohibitive. And so lays the contemporary fault line: privatization proponents view transaction costs and incomplete contracts as solvable technical matters (Savas 2000); critics invoke these theories to question the fiscal benefits of privatization (Sclar 2000).

This essay challenges the logic that quasimarket mechanisms are useful for meeting societal expectations for public service output. My concern is not with short-term contracts for specialized capacity, but the long-term provision of goods and services originating from and financed by the public, including education, healthcare, transit, social welfare, defense, and most municipal functions. The arguments expressed herein center on managed competition, but they apply to all quasimarket inventions.

My core claim is that marketism is inherently at odds with universalism, and that public-private contracts cannot resolve the incongruencies. The idea subsumes theories on transaction costs and incomplete contracts insofar that the contradictions between marketism and universalism explain why transaction costs are prohibitive, or why public-private contracts struggle to achieve both cost efficiency and sustained quality. A major implication is that any improvement in public service performance requires investing in the political system in ways that sensitize policymakers to diverse constituent demands. Robust political democracy, not quasimarket schemes, is required.

A maxim flowing from the PR-PC framework is that public-sector operations should mimic the private sector.² This viewpoint rests on two conditional beliefs: (1) market competition disciplines private firms toward desirable forms of efficiency, and (2) deviations from private-firm practice by public agencies exemplify inefficiency (Gansler 2006; Lane 2000). Such statements, though, fail to acknowledge the dissimilar origins of publicly and privately derived goods, and how origins affect expectations for output. Privately derived goods have a mandate to efficiently serve a commercial niche. In contrast, and often to countervail the exclusionary character of private markets, the demand for publicly financed goods and services originates through a political process that imposes a burden on producers to be inclusive along demographics and socioeconomic status. The weight of the burden generally intensifies as the political system becomes more democratic.

Compared with public agencies, the operational mode of private organizations, especially those in good-producing industries, is linear: design and sell products A, B, and C for markets X, Y, and Z. A mandate for linear efficiency—an operational mode of producing specific products for defined buyers—can be conceptualized as the liberty to choose a profitable customer pool. By targeting a subset of customers from the full universe of persons who might need or desire a good, private organizations engage in exclusion (Samuelson 1954). Price is the common mechanism. Construction firms specializing in luxury homes, automakers assembling high-performance cars, five-star restaurants, and so on, cater to the wealthy. Builders of modest homes, manufacturers of family cars, and fast food joints target customers lacking great wealth. While the rich can afford items marketed to the nonrich, loyalty to class or sensitivity to status will cause the well-heeled to self-exclude. Thus, utilitarian or psychological factors also shape markets. Yet regardless of how they are defined, it is the specificity of markets X, Y, and Z—the demands originating from a consumer niche—that supplies private producers with the information to invent and refine products A, B, and C. A liberty to exclude segments of society from commercial consideration is a primary dimension in the entrepreneurial hunt for competitive advantage, and is ultimately how economic markets are formed.

Public service demand is instead determined by a political body that must, to some degree, answer to a plebiscite. In a democracy, demand is appraised by elected members of society, typically following open deliberations over a community or social need. Financed collectively, elected officials are obligated to consider population diversity—rich and poor, elderly and youth, men and women, immigrant and native, handicapped and able, and so forth, when ruling on the character of a publicly financed good. Unlike economic markets, where buyer traits demarcate good access, public services have inclusive charters with entirely different parameters: population (e.g., children), social mission (e.g., education), or political jurisdiction (e.g., school district). Markets X, Y, and Z do not exist, so there are no specific products A, B, and C. Instead, a mandate toward inclusion imposes a burden to accommodate any disadvantaged constituent that would lack access to a comparable good or service available through private economic markets. Importantly, price ceases to be a mechanism for exclusion.

In private commerce, mining a market niche is the sine qua non for survival, where profit symbolizes the value of an organization’s output. In contrast, in the public arena success is not measured by market share or unit profitability, but by less definitive metrics pulsating through political channels, such as community approval, effect on population well-being, or perceived fulfillment of a social mission. Whereas producers serving private markets are rewarded for capturing profit, producers of publicly financed goods are tasked with balancing the diverse demands of a constituency under a given set of budgetary and legal constraints.

A mandate to include becomes more compelling as political enfranchisement broadens. Conversely, universalism weakens when the character of a publicly financed good becomes defined by elites. This correlation between democracy and universalism explains why democratic practices must often be subverted for privatization to advance.

On this point, PC theorists have it backward. There are few hints of popular revolt to dismantle publicly delivered services beyond what is propagated through “think tanks” financed by economic elites and proselytized by their agents. And there is far more collusion between elected or appointed government officials and private contractors than between politicians, bureaucrats, and organized public employees (Hodge 2000: 142–51). Although PC theorists are correct that socialized operations under a corrupt regime can be dystopian, it does not logically follow that privatization is the corrective path. The remedy for political corruption is reform that curbs improbity. Privatization achieves the opposite by inviting in actors that have a fiduciary obligation to an exclusive circle of investors, further reducing accountability. Laws designed to advance transparency, such as freedom of information law or whistleblower protections, do not usually extend to private contractors. Privatization is thus a contributing factor to the types of government failure that absorbs PC theorists.

PR theorists correctly posit that private economic markets discipline producers toward certain types of efficiencies (Vickers and Yarrow 1988). Where PR theory errs is in conflating the nature of demand from private economic markets with demand arising from public political bodies. Sector homogenization is an essential assumption behind the PR theoretical framework, because if invalid it negates the logic of using private firms to accomplish public ends. The next section develops this line of reasoning by describing the organizational conditions for universalism. The section afterward explains the misfit between universalism and marketism.

Universalism encompasses three organizational conditions that are weak to nonexistent when producing for a private market. First, workers delivering public services are tasked with a range of unconventional and nonroutine responsibilities deemed important to a constituency. Law enforcement officers lecture children on safety, school custodians set the broom aside to protect a bullied child parks employees search for lost hikers, and so forth. Effective response to contingency is required to meet the diverse expectations of citizens and community. Unlike the linear efficiency associated with private production, public service production calls for lateral competency to deal with nonroutine situations arising from varied constituent demands and inclusive social mission.

An overlapping operational requisite is integrated response capacity. Under universalism there are occasions when employees from one functional unit are asked to assist employees in another functional unit to handle a pressing community need. For example, to effectively clear snowbound roads, sanitation workers at many municipalities assist street departments by taking shifts driving plows during snowstorms. Familiarity with the street layout and a commercial driver’s license qualify sanitation workers for this role. Similarly, persons from the street department will assist water department employees with excavation, material transportation, or traffic control when a water main ruptures. Integrated response capacity is a flexible and efficient method of marshaling skill and effort across functional units to complete nonroutine objectives. Developing integrated response capacity enhances the effectiveness of government when dealing with emergencies as well as improving overall service quality.

The importance of integrated response capacity relates to the weight of the social mission and insularity of the responsible organization. Services like education, healthcare, and public security rank high as societal priorities, and thus the schools, hospitals, and law enforcement agencies that carry out these roles are typically organizations that internalize their charter and display a high degree of integrated response capacity. The mission of public schools to advance the intellectual, physical, and civic development of children requires actors within the school community to collaborate, often in small ways, toward this goal. The need for integrated response capacity is especially strong where security and safety are priorities. In prisons, where custody and security are paramount, employees in ancillary units, such as healthcare or food service, are trained to respond to emergencies involving prisoners, including backing up correction officers. Integrated response capacity is perhaps most critical when human survival is at risk, such as in the case of military missions.

Third, for many public services, line workers are required to solve problems where there are no scripted courses of action. This happens when problem uniqueness calls for nonlinear, polydirectional judgments or action, and hence, the quality and integrity of the service turns on professionalism. Teacher performance, for example, depends on how well teachers respond to the unique needs of each child. Imposing formulaic and incentive-driven constraints on the profession have failed because they press teachers to suspend best practice and treat students, via standardized test scores, like a commodity (Rowan et al. 2013). The performance-based culture imposed on government services (Office of Federal Procurement Policy, Office of Management and Budget, and Executive Office of the President 1998) tempts professionals to disregard client uniqueness when pressured to meet remunerated metrics.

For many professional occupations, performance is optimized by shielding employees from pressure to conform to economic incentives that are common at the individual or organizational level in private economic markets. Should teachers attend to the developmental needs of individual children or drill for standardized tests? Should child protection workers involved in critical life-changing decisions for families have “incentivizes” to do anything other than protect the well-being of children in custody? Should police officers receive bonuses for making arrests? Disabling rewards that channel employee decisions toward financial imperatives frees professionals to act in accordance with socially defined, nonlinear objectives for output quality and integrity. Eliminating carrots and sticks fosters professional discretion.

An incentive neutral environment is especially important for occupations that administer public law or concern vulnerable populations. Power imbalance between the service provider and the affected client or community is a critical factor. Moral hazards might pose little harm for services like garbage collection, because homeowners who are unhappy with a contractor have political avenues to vent their complaints. Less so for children, the destitute, the elderly, the handicapped, persons confined to institutions that are isolated from public view, and so forth. One advantage to socialized production is that a governing body has full authority to structure a compensation plan that lowers the risk of moral hazards arising when providers place economic self-interest over client well-being and social mission.

Marketism, defined as the liberty to exclude to exploit a commercial opportunity, offers a relatively clear roadmap for organizational success compared with universalism. Output can be tailored to meet homogeneous customer wants, price and sales data provide feedback signals, per unit expenses and gross margins are quantifiable, and as product demand or input costs change, managers can use this information to adjust operations. Once the organization hones in on a profitable product line, the production process can be discretely decomposed to efficiently yield output, lending to standard metrics for evaluating individual or group performance. Profit accumulation disciplines the organization toward linear efficiency, where employee performance, like products, can be assessed with standard metrics, and rewards can be dispensed to align employee behavior with the goal of efficiently meeting market demand. In this way, the character of the production process is a function of marketism.

Compared with organizations saddled with a universalistic mandate, the rules for surviving in a private market are straightforward. This is not to imply that survival is easy, but only to concur with PR theorists that the environmental carrots and sticks in the private market are sweeter and harder, respectively, than with socialized production (Bös 1991). The golden path in private commerce involves efficiently supplying a targeted area of the economy, whereas the platinum path is monopolizing a good in high demand. A mandate to do so efficiently is intensified by the fact that revenues must be coaxed from private, voluntary transactions, rather than from the relatively guaranteed source of involuntary taxation. Private economic markets are less stable than for goods originating from a political process, making investment risk higher. Firms survive by locating entrenched positions in surplus-generating niches, where they avoid competition and eschew unprofitable clientele.

Locating and mining markets in the private economy does require creativity and ingenuity. However, in most contexts, advanced discretionary judgment is reserved for positions involved in securing a competitive advantage, such as product development or corporate strategy. Nearly all personnel outside of corporate or engineering offices are assigned a role in efficiently supplying product, or overseeing persons that do.³ Nonmanagerial ingenuity might be called on to address station efficiency, or occasionally product quality, but opportunities for substantive influence beyond this scope are rare, if not a ruse (Rinehart, Huxley, and Robertson 1997). Employment for the vast majority of personnel in the private for-profit world consists of defined, sequential, and routine tasks that are channeled toward optimizing financial or operational metrics. Private market environments linearize the roles of most personnel inside the organization.

Organizational obedience to a private market is incompatible with operational conditions for universalism. Publicly shaped values require providers to depart from marketism’s version of efficiency, while the relative low-risk source of public funding grants providers the latitude to do so. Market-oriented metrics, such as unit cost or gross margins are unsuitable because the units are rarely uniform and there is no mandate to accumulate. Strict linear operations that thrive when serving private markets are a form of rigidity that obstructs the performance of nonstandard roles. From the carrot and stick lens, socialized operations are rife with inefficiencies: school districts disproportionately assign teachers to special needs pupils, transit systems accommodate handicapped riders at a cost greater than for the unimpaired, solid waste collection units deviate from routine curbside pickup to perform walk-up services for the elderly, and so forth. Such failures to conform to the optimization behavior desired for private accumulation are, however, precisely the markers for prosocial, inclusive production.

Universalism complicates employee assessment. Employee productivity measures common in private production must be discounted commensurate with the nonstandard nature of public occupations. Standard assessment tools cannot capture job dimensions related to nonroutine duties and requests for intergroup cooperation. Employee performance evaluation is especially difficult for public work that is inherently polydirectional and dependent on professional discretion, as revealed by the woeful failure of student test scores to measure teacher effectiveness (Ravitch 2010).⁴ A valid evaluation instead requires frequent collaboration between manager and worker, with supportive, proximate relationships that enable a holistic, comprehensive assessment of employee performance in relation to socially defined values. Private contracting renders this type of evaluation impractical because workers producing the service are not directly supervised by the public management that is ultimately accountable.

Engaged PR-PC theorists, at this juncture, might counter with a claim that the operational conflict between the instinctive survival behavior of private-market providers and universalism can be dealt with through a cleverly designed public-private contract. The purpose of the next sections is to explain the weakness of this position. The practical application of an arms-length, public-to-private contract establishes forms of incentive dissonance that obstructs the operational best practices for universalism. Dissonance can be ameliorated by using relational contracts, but this entails abandoning the goal of using private contracting to reduce production costs.

A contract defines a set of obligations between two or more parties and provides mechanisms for enforcing compliance. The principals entering into an agreement are assumed to desire a gain, and further, that the gain for any one party is contingent on the actions of other signatories. Were either assumption false, then there would be little reason to have a contract. Thus, a contract’s purpose is to secure cooperative interdependency; they are legal constructs designed to instrumentally direct and constrain party A’s behavior so that party B realizes an objective, and vice versa. Constraint is necessary because the parties have both common and divergent interests, and proper language and enforcement are needed to discourage any one party from opportunistically taking action that robs another of an expected gain.

Public-private contracts carry complications beyond typical principal-agent relations due to the entangled public. Three parties are essentially bound by a public-private contract: the governmental agency, private contractor, and community. Unlike contract relations between two private parties, where mutual observation of performance is presumed by signatories, with privatization contractor monitoring is shared between the immediate principal, government, and affected citizens in the community. The split responsibility impairs monitoring. Actions take place in the community that government cannot observe, and affected citizens are generally poor monitors of agent behavior. In many instances, citizens are unaware of the delegation of authority to a private producer, and even the informed will be ignorant of the contract terms that define contractor rights and responsibilities. Hence, persons directly affected by a contracted service are ill equipped to flag misspecifications, noncompliance, and moral hazards.

Consider the potential for contract misspecifications. To minimize contract disputes and strengthen enforcement, classical contract theory recommends investment in precontract planning to draft detailed standards that communicate party responsibilities and intent. Language is central to adjudicating alleged breaches of contract. Litigants invoking specific language pertaining to performance standards or metrics will prevail over opponents relying on less specific criteria or parol evidence. Classical contract theory therefore advises signatories to anticipate future changes in conditions that might affect the execution of obligations, and then safeguard interests by drafting protective language. The specter of costly litigation drives the demand for language detail and precision.

Language specificity, however, becomes a source of rigidity that is antithetical to the desirable operational qualities for universalism. Airtight language for outsourcing core functions means that nonroutine or unanticipated tasks are excluded. For services that are sophisticated and multidimensional, contract complexity can reach absurd levels (Grimshaw and Hebson 2005: 118). For services that are dynamic, contracts can quickly become obsolete. Even for presciently drafted language, there remains a problem of measuring the scope and quality of good output, which can have numerous dimensions relating to material, protocol, thoroughness, error rates, and so forth.

Contractors have no legal obligation to perform unspecified duties, and are incentivized to adopt a narrow interpretation of their responsibilities under the agreement. Gaps in the agreement and change in demand can be accommodated, but this requires contract renegotiation through a procedure called a “change order” that nearly always revises the contract price upward. An alternative solution is to fill gaps by having public employees from an adjacent unit perform the work, a phenomenon referred to as “burden shifting.” Change orders and burden shifting are evidence of the limitations of classical contracts for achieving lateral contingency. Public-private contracts are simply poor tools for capturing both the contemporary richness of an occupation and temporal modifications in response to changing conditions.

Classical contracts also impair the ability for a public agency to grow integrated response capacity by establishing financial boundaries and interest conflicts between various producer units. Contractors are incentivized to limit their obligations to those defined in their agreement, and to eschew open-ended requirements to share personnel and capital with public agencies or other contractors. Contingent assignments are hard for contractors to price, and may involve duties beyond their capacity. Moreover, the central authority necessary to coordinate an interunit response is weakened, in part because a public agency must reach an accord across multiple contractors, in part because decentralized production dissipates accountability and complicates contract enforcement. Addendums to the contracts to settle competing interests are possible, but once again this step slows the response and escalates the price. Hence, the ability for a governing body to rapidly coordinate the deployment of multiunit resources to handle nonroutine or emergency events is handicapped by a production model governed by classical contracts.

A third weakness of classical contracts as governing instruments is that they undermine the development of environments where employees are empowered to make client or community-focused judgments. Contract language must exist that defines the terms of payment, which in turn establishes a direct path for income maximization. The hazard of prioritizing contract terms over social mission or professional ethics increases to the extent that remuneration is linked to narrow contractual performance standards. Yet regardless of payment design, all contracts formulaically incentivize contractor behavior, adulterating an environmentally ideal climate where law, ethics, and social mission inform professionals making decisions, and where polydirectional options call for client- or community-centered action and judgment.

Payments to vendors come in two general forms: fixed and variable. Fixed payments reward cost-minimization behavior, whereas variable payment arrangements reward revenue-maximization behavior. Contracts can feature both, in which case contractor behavior can be predicted through a weighted assessment of the combined factors affecting net income.

Performance-based payment arrangements are especially pernicious. Fixed payments incentivize contractors to minimize effort for activities that are hard to monitor or are time consuming. Where contractor effort is difficult to verify, the public principal has weak legal recourse if laxity yields poor output. Performance-based systems, which dispense bonuses (or penalties) for meeting (or failing to meet) specified metrics, were introduced as a way to deal with this monitoring problem (Martin 2005; Romzek and Johnston 2000). The concept borrows from the ancient practice of piecework in private industry, whereby producers are rewarded for output rather than physical time on the job (Whyte 1955).

Establishing a crystal path for the contractor to maximize income based on output metrics, however, endangers the affected community by channeling contractor behavior toward the reward, regardless of ethics, social mission, or morality. Making the carrots sweeter and the sticks stiffer through performance-based rewards predictably exacerbates the incentive dissonance caused by classical contract methods. This has been shown through examples of teachers assisting students with standardized tests as a way to protect school funding or to enhance their performance reviews,⁵ and by the examples of corruption from legal institutions that structurally reward zealous enforcement.⁶ And by defining a path for financial success through performance-based pay, contractors gain leverage in future disputes over the scope and quality of output if it can be shown that the behavior was countenanced through a payment system designed by the principal.

Public-private contracts, of the classical variety, are never financially neutral. Quite aligned with carrot and stick theory, the contract payment terms predict contractor behavior and loci of societal risk (Heinrich and Choi 2007). Performance-based pay systems intensify linear efficiency toward metric achievement, as intended, but doing so jeopardizes the affected community when professional discretion and rewards do not align. Risk is especially high for services with humanitarian dimensions. Incentives can be “softened,” for instance with a per diem payment model, but tinkering with pay formulas only creates a new path for income maximization. Contract terms, regardless of design, risk the subordination of social mission to financial self-interest. Paradoxically, contractors that most effectively adapt to the structured contract incentives will also be judged most financially viable in subsequent bidding rounds.

Macneil (1974, 1978) identifies these deficiencies with the classical contract, and proposed relational contracts for dealing with uncertainty in the future execution of party obligations. Under the relational contract model, intent is stated in nonspecific language to allow for adjustments in expectations and obligations. The formal written agreement is supplemented by informal exchanges that involve knowledge and risk sharing, imply co-dependency, and grow trust between the parties. Whereas a classical contract incorporates comprehensive operational detail, the relational contract codifies a pact where the parties cooperatively and iteratively align intent. Theoretically, the relational contract model can accommodate the operational needs of universalism by allowing for adjustments for nonroutine job obligations, interunit functional integration, and to encourage environments where employees in polydirectional roles are free to act without economic coercion.

Pragmatically, though, relational contracts cannot harmonize universalism with the goal of reducing the cost of services. A limitation, as Goetz and Scott (1981) explain, is that vague performance objectives or principles offer weak bonding mechanisms. For instance, “best efforts” obligations for the agent provide courts with no reliable measure to ascertain an alleged breach of contract. And as the plaintiff bears the burden of proof, the principal is at a legal disadvantage in disputes over performance. Disputes are plausible given that best efforts criteria and cost reduction are adversaries. Best efforts imply an expenditure of resources, including human talent, raw material, and equipment; cost reduction asks private agents to do the exact opposite.

To balance these competing objectives, best efforts clauses are often conjoined with termination rights for the principal. Although termination rights contradict the mutual trust condition stressed by relational contract theorists, such rights theoretically can hold an agent accountable to abide by universalistic principles. Terminations are, however, never frictionless, especially when due to convenience rather than cause. Agents can challenge a termination to recoup an upfront investment or if they can proffer evidence of bad faith (Goetz and Scott 1981). Agents, moreover, can protect themselves with language that awards damage payouts for severance. In the very least, terminations mean start-up and conversion expenses for locating and situating a new provider, which are steep for services with idiosyncratic characteristics. Such transition costs explain why mediocre performing contractors are retained long after privatization has failed economically.

The tension between relational contracts and cost efficiency can be discussed relative to the operational requisites for universalism. Pressure to economize will induce the contractor to avoid nonroutine or unscheduled tasks, and reject requests to deploy personnel and capital assets to cooperatively supplement the capacity of other service units. When the terms of remuneration impose harsh financial conditions on the agent, agents stay solvent by adopting a narrow interpretation of their contractual obligations. Forward flexibility, a theoretical advantage to the relational contract approach, becomes crippled by the rules of enforcement, specifically the higher ranking of explicit to implicit language before courts. A relational contract might direct an agent to take best efforts to satisfy a social mission, but the threat of insolvency and drive to maximize income will rule contractor behavior. Government principals that prioritize cost reduction must turn to a classical contract model.

For services that depend on the professional discretionary judgment of frontline workers, the imposition of economizing constraints by way of privatization is even more problematic. Inexact phrases to “protect the public” or “serve a community” are open to interpretation by signatories and courts, ultimately diluting the principal’s enforcement leverage. One strategy is to select contractors with a history of humanitarian practice, and thus use extra-contractual evidence of an alignment with a public mission (Salamon 1995; Ware 1989). This is the underlying rationale for “faith-based” contracting between religious organizations and social service agencies. However, even when the contractor is a community-oriented nonprofit agency, heavy levels of monitoring are necessary to ensure service integrity, compliance with public policy, and to safeguard vulnerable clients. Keen monitoring is necessary as, regardless of the genre of contract and the corporate status of the agent, there is always an incentive to prioritize the financial over the societal.

For reasons tracing to universalism, principals might experiment with relational contracts, but this means forsaking the goal of cost reduction. Relational contracts vest considerable unsecured faith in the ability of a contractor to fill a public mandate, which is achieved by relaxing the contractual enforcement rights of the principal. But this solution is viable only if the principal blunts hard incentives on the agent to engage in marketism. Relational contracts must be matched with financial fat to reward nonlinear contractor behavior toward meeting a social mission. Moreover, because the principal’s enforcement leverage via the public-private contract is diluted, the principal must expend significant resources on direct monitoring. Relational contracts thus admit compromise on the goal of cost reduction. Principals that want to reduce costs are forced to adopt classical contracts.

Let us now syllogize these threads to arrive at the privatization fallacy. Having dissimilar origins, the nature of demand for politically derived goods is not equivalent to the nature of demand for privately derived goods, and nor are the expectations for output. Producers serving private markets are incentivized to be linearly efficient to satisfy a niche segment of the economy. To effectively meet an inclusive social mission, public service production calls for lateral competency, multiunit integrated response capacity, and employment habitats that protect polydirectional professionalism. Marketism and universalism are divergent operational strategies.

It is therefore a fallacy that public administrators can efficiently use the contract process to create long-running systems for pitting viable private providers against each other for public work, that managed competition cost effectively disciplines providers toward social goals, and that sustainable competitive tendering is achievable and the result is superior social value. It is a myth that public services benefit from sweet carrots and hard sticks.

Instead, genuine competition is rare. From an economic perspective, principals seek to minimize transaction costs associated with periodic tendering (Dugger 1993; Sappington and Stiglitz 1987; Sclar 2000); from a political perspective, principals seek to avoid disruption caused by provider turnover. Meanwhile, agents desire steady, secure, and profitable contracts. Thus, both parties are motivated to discard competitive bidding once a mutually acceptable relationship is established. Where periodic tendering is mandated, bidding becomes a perfunctory exercise featuring one wired entry and no genuine rivals. This is especially the case for complex services, which receive far fewer bid submissions (Pack 1989). Once a contractor is operationally and politically ensconced, change orders and contractual waivers are authorized to assure continuity.

Rather than induce greater producer effort on the public’s behalf, it is more common for contractors turn to the familiar survival method of marketism. In this sense, competition does not raise the bar for production standards as much as it rewards artful forms of strategic exclusion. Exclusionary behavior by private agents can be observed across many public services. Social service agencies will sort work or clients to enable contractors to skim lucrative aspects of a public industry (Zullo 2006). Private charter schools will require interviews, essays, burdensome application procedures, or omit services like transportation and second-language instruction to “counsel out” the hard-to-teach and less affluent (Lubienski 2005). Over time, publicly financed goods take on private characteristics.

At core, for private contracting to fulfill a public mission, politically derived pressures on government to produce inclusive output must effectively transfer to private contractors. Privatization, however, adds a degree of separation between the source of demand and producers, which deflects political pressure and obfuscates accountability.

Additional impediments relate to the limitations of the public-private contract. Societal priorities become subordinate to the contractor’s desire to accumulate income by linearizing production toward cost minimization, fee maximization, or some combination under the given remuneration formula. Incentive dissonance cannot be easily resolved, in large part because as governance tools public-private contracts are better at protecting the proclivity of private agents to practice marketism than the right of a government principal to steer contractor behavior toward universalism. Authority by government to flexibly redirect contractor performance carries a price: ex post change orders escalate service cost under a classical contract; ex ante discretion under a relational contract entails a substantial financial buffer to factor in prospective open-ended contractor duties and obligations.

Universalism goes far in explaining why certain goods and services are better produced through socialized means. Private markets allow producers to strategically exclude to serve a profitable niche, making private markets useful for supplying goods people want but that are not deemed essential by society. Socialized production is superior at producing goods that are inclusive in intent, and therefore suitable for goods judged as essential for humankind, even though any single individual may not want the good or would prefer to purchase the good privately. So the question of whether a good should be produced by private or public means turns on societies’ tolerance for privileged access, or the mirror opposite, societies’ insistence on inclusivity.

An advantage of socialized production is that it relies on a superbly relational principal-agent arrangement—direct employment—where government principals and employee agents work in close proximity over career-spanning time periods. Proximity and longevity enable maturation toward an agreement on the balance between social objectives and budget constraints. Compensation systems can be designed that minimize moral hazards. Employee evaluations can be holistic assessments that consider variation in context, assignment, effort, ingenuity, leadership, and judgment toward fulfilling a social mission. Supervisory duties such as task assistance (i.e., education and training), social and emotional support (i.e., assisting with job-related stress), and interpersonal interaction (i.e., nurturing positive relationships between managers and workers) can be accomplished (Barak et al. 2009). Administrative authority to act is streamlined due to an absence of financial conflicts and legal impediments. All make for a relatively efficient transfer of demand from a community to the producers; hence, the political “markets” that shape output scope and quality are relatively effective.

Universalism explains why pay grades in public agencies are flatter than in private firms of comparable size. Steep pay differentials suggest demarcated, nonoverlapping roles, distinguished by level of authority or skill. Compensation disparity reinforces hierarchy and command and control management, where a few strategic and creative persons assign directives for the many. Highly paid CEOs and lowly paid line personnel match organizations with linear operations. Equitable compensation systems, training, and job security, in contrast, support cooperation and joint problem solving among co-workers (Pfeffer 1994), and are broadly consistent with the environmental conditions for universalism.

Universalism explains why fixed salaries or wage rates are preferable to variable and subjectively determined compensation plans, such as merit pay. Variable pay impedes administrative flexibility to match employee talent with organizational challenges. Hospitals function best when experienced doctors treat the most serious patients, child protection agencies function best when social workers handle cases that fit their expertise, education systems are most effective when teachers collaborate to reach students, and so forth. Linking remuneration or career advancement to case or project outcomes risks punishing group cooperation or employees who accept tough assignments. A poisonous balkanization of the operation can emerge as employees motivated by ethics or profession shoulder unrewarded work and thus subsidize organizational rationalists. Marketizing job duties intrinsic to a profession can lead to negative forms of competition across personnel that harm cooperation and performance (Ariely 2008: chapter 4).

Friction between universalism and marketism underlies debates over industry regulation, which can be viewed as a political attempt to force private firms to conform to universalism. In auto, the social objective of public safety was advanced by mandating seat belts, and later airbags, over the objections of industry leaders. Private utilities are likewise regulated to ensure universal access, prevent monopoly price gouging, and to safeguard against the abrupt loss of essential resources to customers. Opponents to socialized medicine rest their arguments on the need for market competition, which historically has equated with the right of insurance firms jockey for relatively healthy pools of customers. A test of the Affordable Care Act (2010), or any replacement, is whether participating insurance firms can engage in strategic exclusion.

Our elucidation on the constraints imposed by universalism helps to explain why complex services are poor candidates for privatization. For instance, privatization offers little to no improvement in the provision of healthcare (Becker and Sloan 1985; Clarke and Estes 1992; Grosskopf and Valdmanis 1987; Ozcan, Roice, and Haksever 1992; Valdmanis 1990), a service that relies heavily on intervention by nonmarket institutions to fulfill a morally inclusive role (Arrow 1963). Universalism also explains why private firms fail to improve whole, struggling public entities. Public school systems that retain private expertise to turn things around rarely succeed (American Federation of Teachers 1995; Christman, Gold, and Herold 2005). A reason for these failures is that private management was not allowed to strategically exclude.

Finally, the distinction between universalism and marketism explains the varied academic assessments of privatization. Meta-analyses and literature reviews that portray privatization in a positive light are often compilations of aftereffects of the sale of state-owned enterprises to private investors (Boardman and Vining 1989; Hodge 2000; Megginson and Netter 2001; Perry and Rainey 1988). Absent from this research is a discussion of the social mandates on the prior divested public organizations, and how standards were relaxed or modified when control transferred to private hands. Liberated to engage in marketism, our formulation would predict that new owners would jettison unprofitable social functions and linearize operations toward monetary rewards. Cost minimization (e.g., reduction in labor force) and revenue maximization (e.g., fee increase) behavior is expected. Assessing whether such “productivity” gains are socially beneficial, however, requires an assessment of the political and social context, placing a value on abandoned social roles and functions or policies affecting inclusion.

There is no academic consensus on privatization, but one roughly observes enthusiasts clustered within the PR-PC wing of economics and skeptics clustered within the field of public administration. Enthusiasm may reflect loyalty to theory, although another factor might be an overreliance on linear regressions of observational data as evidence. Drawing a fair comparison between institutional modes means isolating the treatment effect. With observational data, valid regressions require adjustments for alternative causal factors. Adjustment can be made in the left-hand side of an equation by using precise dependent variables, in the right-hand side by controlling for independent causal alternatives, or both. Regardless, accurate information on what organizations do is needed. A cost or efficiency comparison between privatized and socialized production is spurious if one ownership mode performs functions that are unaccounted for by the researcher.

The influential literature on garbage collection illustrates the value of careful measurement and methodology. Early studies that attributed impressive cost-efficiency gains to privatization used dependent variables derived from aggregate agency expenses: “total operating cost per capita” (Kitchen 1976: 67), “total cost per household served” (Stevens 1978: 439), “cost per yard of garbage collected” (Dubin and Navarro 1988: 231), “gross expenditure on refuse collection” (Domberger, Meadowcroft, and Thompson 1986: 84), or “cost per unit” (Szymanski and Wilkins 1993: 128). The standardization varies, but each numerator is an aggregate agency expense figure. Not one study parses out expenses for supplementary functions beyond routine garbage collection, although critiques of this nature were raised at the time (Ganley and Grahl 1988).

Hints that value loss explained economic differentials between privatized and socialized garbage collection were largely ignored. Berenyi (1981) reports across-the-board cost reductions in ten cases of refuse collection privatization—a finding embraced by enthusiasts. Citizen disapproval that followed private contracting received less notice, even though as Berenyi (1981: 40) explains:

If Berenyi’s cases are representative of the data analyzed in early empirical studies, then absent adjustments for “extras,” the resulting econometric comparison is between private garbage collectors performing routine trash pickup versus public garbage units performing routine collection plus unmeasured supplementary tasks.

Pioneering research on refuse collection featured parsimonious models that overlooked the diversity and complexity of sanitation services. Regressions featured controls for community or regional traits (e.g., population density, local wage rate, and climate), technology (e.g., truck type) or routine pickup characteristics (e.g., location, curb vs. backyard), frequency, and distance from disposal site). Rarely were ancillary functions commonly performed by public refuse collection departments, such as yard waste, recyclables, or dead animal pickup, modeled. Nonroutine or emergency tasks, such as snow removal, were never considered. These studies falsely assumed that the scope and quality of service were equivalent across public and private modes.

Orthodox thinking continues to inform the interpretation of findings. Dijkgraaf and Gradus (2003, 2007) conclude that outsourcing is cheaper, but find no difference between contracting with a private provider or with another government. In conformity with conventional thoughts, the authors attribute the result to a competition effect. An equally plausible explanation is that contracted provision results in a narrower scope of output, regardless of the ownership status of the contractor. Competition is likewise invoked by Bel and Costas (2006) as the reason why “new” private contracting reduces service expenses whereas “old” does not. An alternative conjecture, consistent with Berenyi (1981), is that initial privatization deals often fail to meet societal expectations. Subsequent contract iterations restore valued public functions, but the additions come at a price, eventually closing the private–public cost gap.

Support for the value loss premise comes from research using alternative strategies to correct for unmeasured heterogeneity. Ohlsson (2003) uses two-stage ordinary least squares techniques to adjust for selection bias, and reports that private contracting is slightly more expensive than public provision in Sweden. Without the selection step, which could capture community reservations about service scope and quality, private contracting would have looked superior. Analyzing Massachusetts data, Callan and Thomas (2001) build service complexity directly into the dependent variable by simultaneously modeling refuse collection and recycling, and report no cost advantage from private contracting. Bel and Fageda (2010) similarly include variables on recycling and municipal tourism, and report slightly higher costs with private contracting. Thus, as the regression models better adjust for output heterogeneity, the privatization advantage disappears.

It is quite likely that a large swath of the economic research reporting on the positive efficiency effects of privatized public service production is merely an artifact of the professional methods plied to reach these conclusions. Regressions, the workhorse for economics, involve gathering and analyzing standard measures for both dependent and independent variables. That the measures need to be standard across comparison groups dictates that tests for performance on productivity or cost effectiveness are rigged to favor organizations dedicated to standardized, linearized production, that is, those engaged in marketism. Organizations dedicated toward universalism will be judged less effective because nonstandard contributions go unmeasured. Instead, the social value attributable to universalism will manifest as a negative bias in the relevant regression coefficient. In this way and on this topic, econometric means reify Homo Economicus sentiment.