Nobel laureate research: “The welfare debate can learn from contract theory”

Jan. 12, 2016

How do you make people cooperate when their interests are not exactly the same? That’s’ what contract theory is all about, explains Per Strömberg, professor at Swedish House of Finance and chairman of the Economic Sciences prize committee, presenting the work of 2016 Nobel laureates Bengt Holmström and Oliver Hart.

Professor Bengt Holmström and professor Oliver Hart’s contributions to contract theory research has earned them the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016.  Contracts are a foundation of human society: from marriage and weekly allowances, to venture capital and employment – all cooperation involves some form of contract.

One area where contracts are currently debated, is the privatization of the welfare sector – an issue discussed at a seminar at a seminar at the Swedish House of Finance on November 29.

"Establishing functioning contracts in the welfare sector is complex. The government organizations that purchase services want both quality and cost improvements, as well as innovation that will increase the quality and decrease the cost in the future", explained Per Strömberg when introducing the work of the Nobel laureates.

Quality is hard to describe
If we could write a perfect contract specifying both cost and quality, ownership would not matter, Per Strömberg explained. Whether it’s a public organization or a private corporation performing a welfare service, the terms of the contract would affect the agents’ behavior the same way.

In practice, however, it is often impossible to write a perfect contract that specifies factors like quality or new business innovations.
“We do not really know what quality is, or what a good innovation is, before we see it”, said Per Strömberg.
Therefore, it cannot be adequately described in a contract. In this case, ownership becomes important, explained Per Strömberg.

"Under public ownership, it is generally difficult to provide incentives for either cost efficiency or quality, because the individual employee will not reap the benefits from such improvements.  Private ownership, in contrast, gives much stronger incentives to improve cost efficiency, since this results in higher profits for the private provider.  But when cost efficiencies comes at the expense of quality, this can be problematic and lead to too low quality of service in private ownership."

Is privatization of welfare good? "It depends"
There is no general answer to the question of what is optimal; rather, whether private provision is better or worse than public provision depends on a number of factors. In general, private welfare providers become more attractive when:

• There is less of a negative effect on quality from cost reduction.
• Business innovations, which are non-contractible, are more important.
• There is effective competition between private providers.

If a private company provides a service, it will aim to reduce cost. So, if cost reduction does not reduce quality, privatization can be good. The same goes if innovation is not important, as investments in innovation may only pay off long term and may therefore be disregarded if cost reduction is a primary target. Also, effective competition on the market is required for privatization of welfare services to work well.

If these three factors are met, then yes – private ownership is better than public.

“Given this knowledge, the question of whether or not we should allow profits in welfare sector, treating it as one common market, is rather stupid”, stated Per Strömberg.

“It depends entirely on which sector we are talking about", he explained. "Take the prison service sector for example. There is a big trade-off between cost and the wellbeing and rehabilitation of prisoners. And companies cannot compete to attract inmates to opt for their services. Hence, prison services are not good to privatize.”

Purchaser competence another factor
Another important factor which is often disregarded, is the incentive for government purchasers to do a good job designing contracts and purchasing services.

"I believe that in these models, we sometimes forget that the purchaser is not an all-knowing, optimizing individual without incentive issues. In many cases, the problems with incentives might lie with the purchasers. I think you have to look at the incentives throughout the process”, said Per Strömberg.

Participants at the seminar were professor Per Strömberg, Annika Wallenskog, chief economist at Sveriges Kommuner och Landsting, and Anders Lunander, docent and associate professor in economics at Örebro University School of Business.
The full length seminar is available in the video above. Please note that the seminar was held in Swedish.