Economic incentives under contract supply of local government services

Abstract

It has been argued that organizations which are unable to directly appropriate any of the firm's residual earnings tend to experience various forms of wealth-taking by managers (Alchian and Kessel, 1962). This wealth-taking has been observed in privately-owned, regulated firms (Nelson, 1980) as well as in government-operated bureaus. The results in this paper suggest that the X-inefficiency associated with various forms of wealth-taking may be constrained when external, competitive pressures exist. Niskanen argued that one strategy for reducing the inefficiency associated with monopoly bureaus would be to set up two bureaus to compete for the sponsor's budget in order to generate better information on cost and production functions. At the local level, the Lakewood Plan, by generating information on actual production cost to purchasing cities and to unincorporated area residents, appears to create the desired effect. By generating this flow of information on cost, the Lakewood Plan eases the task of monitoring the performance of county departments. Second, the threat of entry posed by the city bureau, which can always produce services in-house, appears to effectively constrain the X-inefficiency of the county supplier bureaus.