Economic incentives under contract supply of local government services

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. Combined with Deacon's (1979) results, this study suggests that the Lakewood Plan improves overall efficiency in the local government services market in several ways. First, it allows small cities to exploit scale economies by purchasing services from large scale producers. Second, it preserves local autonomy and avoids the welfare losses associated with centralized government (Barzel, 1969). Finally, it imposes some competitive pressure on the producing department ot eliminate managerial inefficiencies. In this era of tax and spending limitations, municipal governments are in dire need of alternative mechanisms for maintaining service levels without increasing service costs. The accumulating evidence suggests that contracting with larger governmental entisties may yield net benefits to both the governmental unit supplying the services (and its clients) as well as to the governmental unit purchasing the services. Copyright Martinus Nijhoff Publishers 1985