Media Briefings

High-Tech Or Low-Profit Businesses – When Government Outsourcing Is Most Desirable

  • Published Date: October 2009


Government outsourcing to the private sector is most cost effective in advanced economies
when it is used to deliver high technology products or to cover low-profitability parts of
public utilities. In very poor countries, outsourcing can be enormous benefit when it leads to
the creation of an infrastructure or service that would not otherwise exist.
These are among the conclusions of research by Emmanuelle Auriol and Pierre Picard,
published in the October 2009 issue of the Economic Journal. Their analysis, which shows
that outsourcing is more desirable for activities with stronger technological uncertainty or
lower profitability (and for governments with tougher financial constraints), provides a useful
grid for analysing outsourcing decisions and public-private partnerships in practice.
The pharmaceutical industry is an example of high technology industry that takes large
investment risk and that receives ‘after the fact’ (ex-post) contractual arrangements from
governments according to their effectiveness.
Private pharmaceutical firms freely choose their investments in R&D and the prices for their
patented drugs. But their most effective drugs are subsidised by governments’ health
insurance programmes. Under such subsidies, consumption is higher than under laissezfaire,
where no reimbursement is made.
There are also effective examples of outsourcing in low profit sectors. Postal services are
outsourced to grocery stores and to gas stations in rural areas of France, Sweden and New
Zealand.
Public transport is outsourced to local taxi companies in rural France, Switzerland and
Canada. The European Commission has subsidy programmes that promote and finance
such ‘taxibus’ services. Taxi companies or drivers invest in their fleets and are free to
operate their business. They nevertheless get subsidies to provide a public service that
allow them to make higher profit than under laissez-faire.
In very poor countries, outsourcing takes the extreme form of laissez-faire and is optimal for
low profitability segments. Sub-Saharan African water, electricity and transport services to
the middle class and the poor are often offered by private enterprises without any subsidy.
Because those countries have very tough budget constraints, it is more effective for them to
let private providers freely serve low-profit segments.
The researchers note that many countries, including Australia, New Zealand, the UK and
the United States, have chosen to outsource the investment and operation in sectors such
as road infrastructures, water and waste management systems, public transports, mail
services, and information and communication technology services.
Most outsourcing decisions imply transferring the control and cash flow rights of such
facilities or services from public authorities to a private entity. Since transferring those rights
does not offer a solution to the lack of competition that prevails in these industries,
outsourcing decisions raise the question of why governments contract out in noncompetitive
markets.
The researchers investigate the properties of outsourcing contracts in the monitoring of
natural monopoly. The contracts combine the transfer of control and cash flow rights to a
private firm before it invests in a project with the possibility of government offering ex-post
contracts during the operation of the project. Ex-post contracts are used by governments to
entice the private firms to reduce their prices and increase their sales.
The study shows that the optimal outsourcing contracts are more selective than the
contracts under public management, that is, low cost firms are offered ex-post contracts
whereas high cost firms are not.
Outsourcing generates a positive fiscal effect because the government is able to terminate
subsidies to those money-losing projects and possibly to collect a franchise fee from the
private investor.
Outsourcing also generates an economic surplus effect as production can be higher under
outsourcing than under a regulated or publicly managed firm.
The researchers show that the set of economic parameters supporting the outsourcing
decision is far from negligible. Moreover, they show that outsourcing is more desirable for
activities with stronger technological uncertainty or lower profitability, and for governments
with tougher financial constraints.
ENDS
Notes for editors
: ‘Government Outsourcing: Public Contracting with Private Monopoly’ by
Emmanuelle Auriol and Pierre Picard is published in the October 2009 issue of the
Economic Journal.
Emmanuelle Auriol is at the University of Toulouse. Pierre Picard is at the University of
Manchester.
For further information: contact Emmanuelle Auriol via email: eauriol@cict.fr; or Romesh
Vaitilingam on 07768-661095 (email: romesh@vaitilingam.com).