Contract Theory and the Failures of Public-Private Contracting

Abstract

The market for public-private contracting is huge and flawed. Privatization proponents predict that privatizing will both cut costs and improve service quality. But public-private contracts for services such as prisons and welfare administration tend to result in cost savings at the sacrifice of quality service. For instance, to cut costs, private prisons skimp on security. Public law scholars have studied these problems for decades and have proposed various public law solutions. But the literature is incomplete because it does not approach the problem through a commercial lens. This Article fills that gap by applying contract-theory principles to public-private contracting.

It argues that certain categories of public-private contracts are subject to systematic biases that cause the parties to impose a cost on service recipients in the form of low-quality service. Because there is a limited competitive market for these services, the contracting parties are not forced to internalize these costs. As a result, contracts tend to be underpriced. Thus, what appears to be a cost-saving mechanism is often, in fact, a systematic market failure.

This Article proposes a counterintuitive solution grounded in contract theory and doctrine to force the parties to internalize the cost of poor service provision. It suggests reading into public-private contracts a mandatory duty to act in furtherance of the public interest. Although efficiency theory assumes that mandatory restrictions on contracting parties are inefficient, a mandatory rule is justified here because the law must protect non-parties to the contract who cannot adequately protect themselves. The Article also suggests that third-party service beneficiaries should be permitted to sue to enforce such contracts.

Keywords: contracts, public-private contracts, contract theory, public law, economics, efficiency theory, agency theory

JEL Classification: K12, K20