Public Contracting : Property Rights

The property rights theory, developed by Grossman and Hart, offers a powerful lens for analyzing situations where contracts are incomplete. Unlike transaction cost economics, which attributes contractual incompleteness to uncertainty and bounded rationality, this theory suggests that the limitation stems from the inability of third parties—such as courts or regulators—to observe and enforce all dimensions of an agreement. The central assumption is that although actors are rational and fully informed, they cannot contract on all future contingencies due to these external enforcement limitations.

At the heart of the theory lies the notion of residual control rights: ownership of an asset grants decision-making authority in all unforeseen circumstances. Because investments are not contractible, the allocation of ownership shapes each party’s outside option in the event of renegotiation, and thereby influences their incentive to invest. Optimal ownership thus aligns with the party whose investment is most critical to value creation.

A key implication is that vertical integration does not reduce opportunism through hierarchy, as transaction cost economics might claim, but instead adjusts bargaining power by reallocating residual rights. This leads to counterintuitive results: integration may be suboptimal when investments are symmetric, and full privatization may yield excessive cost-cutting at the expense of quality.

This framework has been particularly influential in analyzing public contracting. Hart, Shleifer, and Vishny extend it to the privatization of public services, showing how asset ownership affects managerial incentives. A private operator, owning the assets, has strong cost-cutting incentives but underinvests in quality. A public manager underinvests in both cost and quality due to weak residual claims. The optimal choice depends on the trade-off between cost savings and quality degradation, especially in settings where users cannot discipline providers through competition. Hence, privatization is preferable when adverse effects on quality are limited and innovation potential is high.

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