Public Private PartnershipsStéphane Saussier

Sorbonne Business School – IAE de ParisSaussier@univ-paris1.frhttp://www.webssa.net

Class 2

TheMake orBuy Decision

Starting point:TheNatureoftheFirm

R.H.Coase 1937

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Organizational Choices andContracts• Themainstream’spointofview• Assumptions

• Whatisamarket?• Whatisafirm?

X1X2X3

Qblack box

• The neoclassical theory of the firm doesn’t help much.• The firm as a black box.• Boundaries of the firm assumed.

Why dofirms exist?Andwhat for?Towardatheory ofthefirm

R. H. Coase(1910 - 2013 )Nobel Prize 91

« The main reason why it isprofitable to establish a firmwould seem to be that thereis a cost of using the pricemechanism » (Coase 1937)

« TheNatureoftheFirm »1937

• Context:• Written in 1935. Started in 1932. Coase is 21 years old then• Three announced objectives• Explain why firms do exist• Give a clear definition of what is a firm• Find out the trade-offs at stake explaining the choice

between market and firms• Only one objective will be achieved

Why Firms doExist?

• Thereexist acost inusing themarket asacoordinating device• Discovering the price• No benevolent auctionner• Defining contractual relationships

• Costs ofusing themarket are« transactioncosts »

What coordinationdevices inthefirm?

«If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so_» (Coase 37)

• Labor contract

• Long term agreement

• Incomplete agreement

• Authority as a coordinating device specific to the firm

Thesizeofthefirm.

• Thesizeofthefirmisnotitsoutput(Q)butthenumberoftransactionsoractivitieswithinitsboundaries.

Ronald H. Coase (1910-)

A1 C3 D4 E5B2

What arethelimits ofthefirm?• « Firm will tend to expand until the costs of organising an

extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm. » (Coase 1937, p. 395)

• « it may be that as the transactions which are organized increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest, that is, fails to make the best use of the factors of production». (395-396)

• «A firm will tend to be larger the less likely the entrepreneur is to make mistake» (395-396)• Highlight the cognitive limits of the manager

WhatarethelimitsofCoase1937?

• Tautological hypotheses• A questionable definition of the firm• No clear definition of what are transaction costs• No credible limits for the expansion of the firm

– A « socialist » analysis!• BUT one main central message: The existence of transaction

costs oblige economists to ask and analyze NEW QUESTIONS that become relevant.– What are the frontier of the firm?– Can be extended to the question of the frontier of

government

Make or buy? Transaction Cost THEORY

• Startsfromthe70’s• Startingpoint:let’stakeRonaldCoase seriouslyand

identifythesourceoftransactioncosts- costofusingthemarket

• Antitrustissuesatthebeginning• Atheoryofthefirm,contractsandverticalintegration• Atheorythatappliedtobothprivateandpublic

contracts– Firstcasestudy1976CATVcase

• Anempiricalsuccessstory

Williamson O.E.U. of CaliforniaBerkeley1932 -

Transaction Cost Economics

Williamson O.E.U. of CaliforniaBerkeley1932 -

1975 1985

Williamson, Oliver E, 1973. "Markets and Hierarchies: Some ElementaryConsiderations," American Economic Review, vol. 63(2), pages 316-25, May.

Transaction Cost Economics: basics

• A set of “realistic” behavioral assumptions – Bounded rationality – Opportunism

• Coupled with characteristics of the transactions– Complexity and/or uncertainty – Small number relationships / asset

specificity

• Generating transaction costs

Williamson O.E.U. of CaliforniaBerkeley1932 -

Transaction Cost Economics: basics

Williamson O.E.U. of CaliforniaBerkeley1932 -

BoundedRationality

Complexity/

Uncertainty

Incompletecontracting

PossibleOpportunism

SmallNumbers

Relationship

Need forCredible

Commitments

WhatAreTransactionCosts?TheCostsofcontracting.

Ink costs

Negociation costs

Ex ante Costs

Search costs

Contract

costs

Maladaptation costs

Renegociation costs

Ex post Costs

Monitoring costs

Breach costs

Assetspecificitylevelisendogenous

• Small number relationships and asset specificity

• Uncertainty

Organizational surplus

Rooms for opportunism

Lock-in effect and long-term relationships

The Hold-Up Issue

Lando: « But, this was not our initial agreement!»

Darth Vader: « I changed the terms of the agreement. Consider yourselves happy that I did not change them more.»

"It's always been a danger, but it looms like a shadow over every-

thing we've built here. But things have developed that will ensure security. I've just made a deal that will keep the Empire out of

here forever."

One example!

• « But it is difficult to be clear and comprehensive in defining service targets. Governments tend to be nervous about providing only general performance obligations, fearing that the concessionaire will do less than they deem necessary. An example in the United Kingdom helps show why. In the competition for a build-operate transfer (BOT) contract for a prison, granted under the country’s private finance initiative, it turned out that the winning company’s bid was based on a plan to house several prisoners in each cell. The government had wanted single occupancy, but had forgotten to specify this in the tender documents. »

M. Klein, World Bank, Bidding for Concessions—The Impact of Contract Design, 1998

http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1303327122200/158klein.pdf

Another example• Velib’• Signedin2007for10years• Renegotiatedin2009and2011• Why?Toomanystolenbicycles(morethan60%ofthetotalfleetthefirstyear)

• Unanticipated?• Whatwassupposedtobefreeforthecityendupata16M€costfor

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WhatImplications?

• Never choose to integrate only for production cost considerations: market always do better!

• Only transaction cost considerations should drive the decision– If no credible commitment is possible then a more

complex and costly governance structure is needed, namely vertical integration or regulation

– Main drawback of integration ? Administrative costs (i.e. low incentives)

Whatisdrivingverticalintegration?

• Proposition 1 : The more the transaction needs specific assets to be realized, the more probably externalization strategy will be difficult.

• Proposition 2 : The more the transaction is uncertain, the more externalization will be difficult, especially if the transaction necessitates specific investments.

An Empirical Success Story ?

• Source: Boerner & Macher 2008

To know more • LevinJ.&S.Tadelis ContractingforGovernmentServices:TheoryandEvidence

fromU.S.CitiesJournalofIndustrialEconomics,2010,58(3):507-541

– AnempiricalanalysisofprivatizationbyU.S.cities• +1000UScities/+60localservices

– Mainempiricalfindings:• Servicesforwhichitishardertowriteandadministerperformancecontractsarelesslikelytobeprivatized.

– Complexity– Hold-upsensibility

• Therelationshipisgreaterforlargerandmoreurbancities.– Oneexplanationisthatthesecitieshavetheresourcestousein-houseprovisionandperhapsalsoamorereadilyavailablepoolofexternalproviders.

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Levin J. & S. Tadelis Contracting for Government Services: Theory and Evidence from U.S. Cities Journal of Industrial Economics, 2010, 58(3):507-541

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Franchise-bidding (Demsetz 1968) and transaction costs

Choice of the Private Operator

Competition for the field

Contract renewal

Competition for the field

Service specification

Contract execution

t

O.E. Williamson 1976 – CATV CaseFranchise-bidding’s failures (1)

• The difficulties to put firms in « competition for the field »

– Price criteria does not always resume what is expected from the private operator

– Price criteria might be complex (price vector instead of one single price)

– Aggressive bids àand then quality shading (see the Nasa example!)

– “Winners’ curse”

– Collusion: ex: case of urban transport in France (2005) – penalty 12M€

– Corruption: anti-corruption law in France in 1993

– Few bidders

– CATV?

Potential (imperfect) solutions– Bids formulated in terms of a constant revenue stream

• Least-Present-Value-of-Revenue Auctions and Highway Franchising”, (with R. Fischer and A. Galetovic), J. of Political Economy,109 (5), October 2001, 993–1020.

$

Years

Construction Discounted Revenues

T0

A

Expected Traffic

Low Traffic

High Traffic

T1

Maximum length

Franchise-bidding’s failures (2) • Difficulties to enforce (incomplete) contractual agreements

– Disconnection between price and costs over time

– Penalties are difficult to apply (See the CATV Case)

– Non-verifiable dimensions of the contract

• Opportunistic behaviors might arise

– Efforts to evade or renegotiate the contract (Guasch2004)

– Underinvestment

– Lower level of quality than promised (but not enforceable)

– Absence of responsiveness to consumer’s needs

• Connected to the demand risk, transferred or not

– Concession vs. PFI

PPP’s failures (3)

• Long term contracts and refranchising are problematic

• Specific Investments Þ Long term contracts ÞLack of bidding parity at franchise renewal (« Fundamental transformation »)– Water sector and urban transport in France: +85% of

renewed contracts with the same firm!

Toward aformalization ?Make orBuy?TheProperty RightTheory

ANarrowPicture

¨ Pathbreaking article: GrossmanS.J.,andO.DHart[1986],TheCostsandBenefitsofOwnership:aTheoryofVerticalIntegration,JournalofPoliticalEconomy,94,691-719.

¤Oneannouncedgoal:Toproposeagoodformalizationofthetransactioncosttheory

¤Onemainstrategy:Theassumptionofboundedrationalityisnotusefulinordertobuildanorganizationtheoryneithertheassumptionofasymmetricinformation

O. HartHarvard U.Nobel 2016

Assumptions¨ Asetofassumptions

¤ Rationality¤ Symmetricinformation¤ Riskyenvironment¤ Incompletecontracting

¨ Contractualincompletenesscomesfromasymmetricinformationorboundedrationalityofthirdparties(notformalized)

¨ Somespecificinvestmentsareobservable,butnotverifiable¤ Mainlyhumanassetspecificity

¨ Atheoreticalframeworkthatiscriticized,mainlybecauseofinternalinconsistency:Tirole 1999Econometrica andJournalofLegalStudies 2000.

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Mainconclusions• Contractualincompletenessopensroomforhold-upbehaviors.

• Agentsanticipatethis.Thisanticipationdistortsexanteinvestments

• Propertyrightsdistributionpermitstoinfluencesuchdistortion– Bychangingoutsideoptions

• Thereisnowaytoreachthefirstbest

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However…• Verticalintegrationissues:

– Integrationdoesnotchangethelevelofcontrolornegotiationpowerperse

• Noncontractibleinvestmentsarestillnoncontractible!– Integrationgivestothepartythatownstheassetsahigheroutsideoption.Incentivestoinvestarethusinfluencedbypropertyrights

• « Itwould be too easy toconstruct atheory ofthefirm with theassumption that incentives aredecreasing inthefirm compared tothemarket »(Hart1995)

– Whointegratesiscrucial:Partywiththemorecrucialspecificinvestmentsshouldintegratetheother

• but :ifinvestmentsmadebypartiesareequallyimportantthenwhatisoptimalisthenon-integrationsituation

TCTvs.ICT:Somequotations• "Theneed,plainly,wastodevelopformalmodelsofincompletecontract.That

gotunderwaywiththepublicationofthepath-breakingpaperbySanfordGrossmanandOliverHart[1986]"(Williamson[1993],page42).

• "ItisnoteworthythatGrossmanandHart(andrelatedpapersofthiskind)workfromtransactioncosteconomicspremises- albeitwithterminologicaldifferences.ThusGrossmanandHartemploythetermsnoncontractibility andnonverifiability ratherthanboundedrationality.Andtheyreferto"relationship-specificinvestments"ratherthanassetspecificity.Unanticipatedstaterealizations,andtheneedtoadaptthereto,arewhatposecontractualstrainsintheirmodel.Souncertaintymakesanappearance"(Williamson[1990],page16).

Versus• Ifsomeofthecentralandcriticalideasintransaction-costeconomicsas

formulatedbyWilliamsonhavebeencaptured,others,equallyimportant,havebeenmissed.Inparticular,mathematics-basedtheorystilllacksthelanguageneededtocaptureessentialideasofboundedrationality,whicharecentraltoWilliamson'sconceptsoftransactioncosts andcontractualforms”DavidM.Kreps [1996],page2.

• Williamson1999,2000,2002,Whinston 2003

Toknowmore:Hart-Shleifer-Vishny 1997– TheProper ScopeofGovernment

Quarterly JournalofEconomics

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• Theincompletecontracttheoryisnowoneoftheleadingtheoreticalframeworktoanalyze“makeorbuy”issues

• Surprisingly,thisisnotyetthecasewhenthisquestionisappliedtothepublicservicescases

• Firststep:Hart-Shleifer-Vishny 97- withanapplicationtotheprisonsinUS.– Nowthisisacanonicalpaperonthisissue

Next Class

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Beprepared tointeract• HowdowemeasurePPP’sefficiency?• Areweabletoconductcomparisonbetweenprojectsfinancedthrough

PPPsandotheridenticalprojectsorganizedthroughconcessionortraditionalpublicprocurementcontracts?– Arethosecomparisonsmadebeforeorafterthedecisiontostartaproject?

• Howdowedecide,atthenationallevel,whichprojectsaretoppriorities?• Whatisacomplexcontract?• Howdowefollowrenegotiationsincomplexcontracts?Ex:Philarmonie

deParis• WhichcountrywouldbeTHEbenchmark?• ExampleofagoodandabadPPP?• Howtomaintainhighlevelofcompetitionincomplexglobalcontracts?• …

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