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

01 Oct 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.

''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

University of Toulouse | eauriol@cict.fr

Pierre Picard

University of Manchester