Monitoring and Internal Efficiency: A Comparison of Public and Private Ownership

The paper compares the productive efficiency of public and private enterprises in an adverse selection model with managerial effort. Under either ownership structure, the firm's manager has private information on his ability. The principal can invest in monitoring to elicit this ability. As a benchmark, we show that the manager's equilibrium effort in absence of monitoring is strictly higher in a public firm where the principal is a benevolent government. These results may be reversed when both principals have access to a monitoring technology. We show that, under the optimal monitoring and contracting decisions, the public principal may refrain from audits, while the private principal monitors. In this case, managerial effort and thus productive efficiency can be higher in a private firm. Conversely, in situations where both principals endogenously monitor, effort and welfare levels under either governance structure coincide.