Joanna Tyrowicz

Limits of state

Institutional Economics

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“But I thought you were going to talk about econometrics?!”

State (especially welfare) is obliged to assure provision of some services, BUT...

...it does not have to provide them! Face it: most of them CANNOT be provided „inhouse” Distinction between financing and provision

Then the economic question: What to provide and what to contract? The criteria! How to contract?

Schedule for today: Theory of contracting, PPPs Empirics of PPPs Empirics of PPPs in the context of development

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What is a Public Private Partnership?

Any collaboration between public bodies, such as local authorities or central government, and private companies tends to be referred to a public-private partnership (PPP).

PPP cover a wide variety of working arrangements and offer the opportunity for the private and public sectors to become involved in a relationship which will see the expertise of both sectors being utilised to deliver and maintain public sector assets and services. PFI - Private Finance Initiative Joint Ventures Outsource Partnerships

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Why do it ? Central Government Policy

Governments should be keen to expand the range of private public partnerships because they believe it is the best way to secure the improvements in public services that politicians promised at the last election.

Devolved Government Policy Delivering better and modern public services should

be a top priority central and local administration. Public Private Partnerships (PPP) are an important part

of this modernisation agenda and provide the basis for continuing real step change in how public services are delivered across countries.

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What is the problem about? Possible advantages:

lower capital constraints; incentive-based contracts; encouragement of innovation; lower production costs (scale and scope economies).

Possible disadvantages Legal

Not defined responsibility of contractors Not defined relations between sectors

Institutional Unwillingness to cooperate Not defined data exchange and data use procedures Weak administrative capacities Job protection!

Cultural Society’s distrust => corruption claims, etc.

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The Temptation

“Knowledge is Power”

CommercialCompetitive AdvantageIntellectual Property

Private Public

Political Specialist Knowledge Job Protection

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Economics of PPPs The efficiency of PPP: remains an unresolved empirical question At the theoretical level:

Transaction Costs Economics Williamson 1976, Williamson 1999

Incomplete Contracts Theory Hart-Shleifer-Vishny 1997 ; Hart 2003 ; Bennett & Iossa 2002

Arbitrage Theory: Bentz & Grout 2002

A TCE approach would stress a simple idea: The common error to be avoided is to pronounce that governance

structures are efficient or inefficient without reference to the transaction… there are transactions for which the firm is superior to the market, its bureaucratic disabilities notwithstandingO.E. Williamson 2002, page 20.

Possible drawbacks of PPP : contractual costs Transaction costs may, in certain situations,

overcome advantages in terms of production costs

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What are potential transaction costs?

Choice of the Private Operator

Competition for the

field

Contract renewal

Competition for the field

Service specificatio

n

Contract execution

t

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Franchising: problems to overcome

EX ANTE: Specification of the franchised service and effective competitive bidding Imprecise specification adverse selection problem (the winner’s curse) Small number of bidders Price and quality do matter Artificial or obscure award criterion.

EX POST: Risks of opportunism

Delays in construction and provision Efforts to renegotiate the contract Lower level of quality than promised Absence of responsiveness to consumers’ needs Price increase

Risks of maladaptation Price-cost divergences Indeterminacies

Those problems are particularly important when the transaction is uncertain and needs high level of asset specificity

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Potential transaction costs: solutions exist!

Contractual solutions: Choice of the operator

Menu auctions Pre-qualification criteria Bids formulated in terms of a constant revenue stream Allocation of risk Minimum level of quality required

Execution stage Dissuasive but realistic penalty clauses Enforceable sanctions; Monitoring and accounting

procedures; Capacity of expertise ‘Open Book’ Policy – Yardstick competition ; Information

transparency

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Potential transaction costs: solutions exist!

Institutional solutions: Credibility of the contracting parties

Reputation Institutional dotations (corruption, property rights

…) Laws that constrain contractual choices and potential

opportunistic behavior No institutional choice is better than another a priori. The choice between PPP and direct public management

depends on the characteristics of the transactions (asset specificity / uncertainty / complexity)

Recent developments show that solutions may exist that qualify PPP in many situations

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„What should government buy?” Paper by Bentz, Grout, Halonen (2004)

The basic issue: there are assets and there are services – THEY DIFFER!

If the quality of assets (e.g. the of subsequent operations) depend on initial asset investment, there is a problem Whether quality is high becomes private information

of the builder (moral hazard problem) Whether costs of operations are high become private

information of the service provider The government – if it contracts – has to provide

incentives to ensure that service provider reveales the correct cost, i.e. there is an adverse selection problem at the service provision stage that creates informational rent for the service provider.

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„What should government buy?” In traditional procurement, government has to separately

incentivise the builder (to overcome the moral hazard problem) and apply the revelation mechanism for the service

provider (to overcome the adverse selection problem, „revelation mechanism”).

In a PPP model the same company builds and then operates the asset to provide the service. Information rent gained at the service delivery stage

is greater the more often costs of delivery are low Consequently, the consortium (of builder and service

provider) has the incentives to build the best possible asset.

PPP gives high quality „for free”

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„What should government buy?” BUT:

If the costs of assuring high quality at the investment stage are high, this „for free” mechanism no longer works

PPP can still provide high quality, but „revelation mechanism” is overpaid (exact IC constraint not possible)

Credibility of government not to have soft budgetary constraints „afterwards”

Conclusions Implementing PPPs when traditional government costs

are high are not effective (examples???)

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Contracting to FPs vis-a-vis NFPs? Paper by Bennett and Iossa (2005)

Comparison of FPs and NFPs Incomplete contract approach Firm may make uncontractible investment,

researching innovative approaches Control rights give power to veto implementation of

innovation Consider three alternative scenarios

No conflict: innovation increases both profit and social benefit

Conflict of type 1: innovation increases social benefit but unprofitable

Conflict of type 2: innovation increases profit but reduces social benefit

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Contracting to FPs vis-a-vis NFPs? Model

G and NP/FP agree on a contract that specifies verifiable basic standards

NP/FP may make investment, researching innovative approaches

x : level and cost, in terms of disutility of effort, of the investment made

x uncontractible Ownership of project gives veto power on

implementation of innovation (control rights) Under tendering, G has control rights Under partnership, NP/FP has control rights Social benefit from innovation (if implemented): B0

B(x) Profit from innovation (if implemented): π0 π(x),

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Contracting to FPs vis-a-vis NFPs? B(x), π(x) are observable but uncontractible

NO CONFLICT SCENARIO: Bx, πx > 0

CONFLICT OF TYPE 1 SCENARIO: Bx > 0 > π x

CONFLICT OF TYPE 2 SCENARIO: π x> 0 > Bx

Assumption: Bx + πx > 0 (it makes sense to invest!)

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Contracting FPs vis-a-vis NFPs? Conclusions

under partnership, firm internalizes profit effect fully but no internalization G’s social benefit effect

Under tendering, firm shares social and profit effect with G The highest investment is achieved by

No Conflict: tendering to FPs (if Bx and/or π high), otherwise partnership with FPs

Conflict of type 1: tendering to FPs (if Bx and/or π high), otherwise partnership with NFPs

Conflict of type 2: partnerhisp with FPs The highest social benefit is achieved by

No Conflict: as above Conflict of type 1: as above Conflict of type 2: tendering to NFPs

Even if NFPs care more than an FPs about B, B may be greater with FP!!!

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Empirical setting, Saussier (2005) Water distribution, only this time in France

Data sets from the French Environment Institute and the French Ministry of Agriculture

A representative sample of all the French local authorities 5,000 local authorities in 1998

Restricted to 4,443 observations in statistics Restricted to 3,613 observations in econometric tests

Account for more than 50% of the consumers The question: Price, cost and organizational

Asset specificity Physical investments are specific (site specificity)

Complexity Mainly due to

difficulty of the treatments for producing drinkable water (e.g. the quality of the water before treatment)

difficulty of transporting water to the consumer (the density of population)

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The case of water supply in France

Decision: local authorities decide, not State

A great variety of organizational choices

39%

3%4%

51%

3%

DirectManagement

IntermediaryManagement

Gérance

Lease contract

Concessioncontracts

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Institutional environment and potential transaction costs

Drawbacks of PPP resulting from contract incompleteness can be reduced by the institutional framework

The intuitu personae principle May avoid problems linked to the choice of the

operator Risk of corruption/collusion

PPP are « administrative » contracts An asymmetric position between contracting

parties Ex post renegotiations take place within a rigid

framework

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The case of water supply in France – USE OF PPP

The use of PPP

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The case of water supply in France - PRICES

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Prices and organizational choices: a first look

Organizational choices Mean (PRICE)

DIRECT MANAGEMENT 116,81

LEASE 148,8CONCESSION 141,61

INTERMEDIARY MANAGEMENT

156,12

GERANCE 201,23

In euros for 120 m3, without tax

Two possible interpretations Collusion prices - PPP are inefficient because of ex ante transaction costs PPP are specialized on complex transactions - PPP are efficient

Prices for local authorities that do not contract out the service are lower

The price difference between lease and direct public management is 32 €

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Prices and organizational choices: an econometric test

«Naïve» OLS equation, controlling for other parameters than organizational choices that may have an impact on prices:

PRICE i Zi ORGi const i

R2 = 0,50 Lease contracts account for 27 € in the price (average bill of 140 €) All types of PPP lead to an increase of price paid by the consumer

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Prices and organizational choices: an econometric test

Cost structure might be different from one organizational choice to another

Estimate 2 equations:

Possible selection bias Organizational choices are not randomly chosen

TCE propositions Heckman Method

1i Z i 1i (1)

2i Z i 2i (2)

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In what situations could drawbacks overcome advantages of a PPP?

Robust probit estimate of lease vs. direct public management

Complex transactions (complex treatments, low density of population) are more probably organized through lease contracts

Non-linear effect of the population size More than 75% of observed choices

accurately predicted

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Prices and organizational choices: an econometrical test

Table 8. Estimated average prices for each governance choiceDirect Management

observationsLease Contracts

observationsEstimated prices (n=1099) (n=1865)

Mean price if all services are provided through Direct

Management114,99 136,61

Mean price if all services are provided through Lease

Contracts124,11 148,8

Correcting for selection bias, direct public management is still the most efficient organizational choice

However the price difference between lease and direct public management decreases again (About 10 €)

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Experiences of developing countries

Paper by Estache (2004) PPP in infrastructure investments ($790 billion) Steadily growing 1970s-1997, droping afterwards Some evidence of catastrophe:

50% of contracts in LA renegotiated Reasons for „divorces” largely uknown

Why such results? Part of PPPs where privatization related (railroads, roads,

healthcare, etc.) Government: Quick budget revenue, and long budget

costs... Providers: improving access (pressure), worse clients

(lower profits) Rate of return versus total cost of ownership considerations

Balduzzi (2007) paper – theoretical review to start from…

Assignment?Thank you for your attention!

jtyrowicz@wne.uw.edu.plhttp://www.wne.uw.edu.pl/jtyrowiczhttp://www.development.wne.uw.edu.pl

-> Development Workshop & Institutional Economics (2nd year)