Canadian Public Policy

The Economics of Public-Private Partnerships

Author(s): Jean-Etienne de Bettignies and Thomas W. Ross
Source: Canadian Public Policy / Analyse de Politiques, Vol. 30, No. 2 (Jun., 2004), pp. 135-154
Published by: University of Toronto Press on behalf of Canadian Public Policy
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The Economics of Public-Private
Partnerships
ANDTHOMASW.
DE BETTIGNIES
JEAN-ETIENNE Ross
SauderSchoolof Business
Universityof BritishColumbia
Vancouver,BritishColumbia

Les gouvernements, a l'interieurdu Canadaet a traversle monde,cherchentde nouveauxmoyensde fournir

aux contribuableset aux usagersdes servicespublicsa moindrecofit. Beaucoupd'entreeux ont choisi de
formerdes partenariats secteurpublic/secteurpriv6qui impliquentle secteurpriv6dansunebien plus large
mesure.Ce choix est souventcontrovers6et les debatsse constituentregulierementa partird'uneiddologie
plut6tqu'a'partird'uneanalyseconsciencieuse.Cetarticleajoutenotrecontribution aupetitnombred'6tudes
consacr6esa ce partenariat,
d'universitaires en examinantles facteurs6conomiquesqui sonta la basede ces
relations,de manierea decouvrirleurs v6ritablescofits et benefices.L'objectifest de nous aidera mieux
comprendreoih et comment ce systeme de partenariatpeut constituer une m6thode efficace pour le
ddveloppementdes servicespublics.
GovernmentsacrossCanadaand aroundthe worldare looking for new ways to deliverpublic services at
lowercosts to taxpayersandusers.Manyhavechosento formpublic-privatepartnerships(P3s), involving
the privatesector to a much greaterextent.This choice is often controversial,with the debatesroutinely
drivenby ideologymorethancarefulanalysis.This paperaddsto the limitedacademicliteratureon P3s by
reviewingthefundamental underlyingeconomicsof theserelationshipsto get at theirrealcosts andbenefits.
Thegoal is to helpus betterunderstandwhereandhowP3s maybe an efficientmechanismfor the provision
of publicservices.

INTRODUCTION "alternativeservicedelivery"(ASD), andthe more

aroundthe worldstruggleto
governments
As providemoreandbetterservicesto theirciti-
zens on limitedbudgets,organizationalinnovation
has cometo the deliveryof publicservices.Justlike
their private sector counterparts,public sector
decisionmakersare now askingjust what services
theyshouldprovidethemselvesandforwhichshould
they contract with private sector partners.This
searchfor new methodsfor the productionandde-
liveryof publicserviceshas given us new concepts
(or at least new labels) such as the more general
specific"publicprivatepartnerships" (PPPsorP3s).
ASDrefersto thefull set of alternativearrangements
thatcansupplygoodsandservicesthatwouldother-
wise have been provided directly by public
enterprisesalone. This will include P3s, but also
contracting-outof services and outrightprivatiza-
tion. The effort to find better ways to produce
governmentservicesis notmerenibblingaroundthe
edges of government- to some it representsa sea
changein theverynatureof government;it haseven
been referredto as "reinventinggovernment"(see,
e.g., OsborneandGaebler1993;Trebilcock1994).

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004

136 Jean-Etiennede Bettigniesand ThomasW Ross
Ourgoal in this paperis to worktowardan under-
standingof the underlyingeconomicsof P3s such
thatwe mightbe betterable to advisegovernments
withrespectto whereandhow theymightrepresent
betterways to deliverpublicservices.
The term public-privatepartnershipis used in
slightlydifferentways with the resultthata precise
definitionto whichall will agreeis elusive.TheBC
Ministryof Financeoffereda straightforward defi-
nition that focused on the use of P3s to replace
traditionalpublicprovision:"Public-private partner-
ships (P3s) are contractualarrangements between
governmentanda privatepartyfor the provisionof
assets and the deliveryof services that have been
traditionallyprovidedby the publicsector"(2002).
Allan (1999) reportsseven definitionshe has un-
covered.' The central element reflected in these
definitionsand others is the sharingof decision-
making authority, which contrasts with the
"supplier" relationshipin whichgovernmentdecides
exactly what it wants and buys it and the "public
enterprise" modelin whichthegovernment produces
the services with no private sector involvement.
Many definitionsalso mentionthe sharingof re-
wardsandof risk.The sharingof rewardsis clearly
necessaryif the privatesectoris to be involvedvol-
untarily,2and the idea thatP3s permitthe optimal
allocationof risk is pervasivein the P3 industry's
literatureandwill be addressedin detailbelow.
Whilesome examplesof P3s go backdecadesor
more, there can be little doubt that interestgrew
rapidlyin the 1990s.3TheUnitedKingdomparticu-
larly embracedwhat were called "privatefinance
initiatives"(PFIs)to get privateparticipationin the
provisionof publicservicesbeginningabout1992.
InitialBritishPFIs were concentratedin the trans-
portationsector,but morerecentlythey have been
used in a varietyof areas,includingroads,hospi-
tals, andschools.
Recent high-profileexamplesof public-private
partnershipsin Canadainclude the Confederation
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Bridge connecting New Brunswick and Prince
EdwardIsland, completedin 1999; the 407 ETR
highwayin SouthernOntario(firststagecompleted
in 1998);andthe CharleswoodBridgein Winnipeg,
completedin 1995.It is clear,however,thateven in
CanadaP3s havegone beyondroadsandbridgesto
include,forexample,airports,schools,incineration
facilities, waterandwastewatertreatment,medical
facilities, recreationfacilities, propertymanage-
ment, and utilities.4 In a numberof countriesand
even someCanadianprovinces,specialoffices have
been createdwithinthe governmentsto collect P3
expertise and promote the use of P3s in certain
classes of projects.5
While holding out the promiseof a more effi-
cient allocationof society's resourcesand a better
"valuefor money"for taxpayers,P3s arenot with-
outtheircritics.Publicsectorunionsareparticularly
opposed to what they see as attemptsby govern-
ments to shift their work to private sector firms
payinglowerwages andofferingan inferiorquality
of service (see, e.g., CUPE2002). And thereis no
disputingthe fact that some P3s have not worked
out as well as projectedby the partners.In theirex-
amination of P3s, which included reviews of a
number of specific projects, Boase (2000) and
Daniels and Trebilcock(1996) recognizeboth the
potentialbenefitsand costs of P3s. The costs they
cite includelack of transparencyand accountabil-
ity, and the potentiallyserious problemsthat can
arisewhencontractsarenot well-designed.
This paperis at once an introductionto an im-
portant,and increasinglyso, area of government-
businessrelationsanda call for research.We argue
thatbasic economictheoryis extremelyhelpfulin
understandingthe potentialfor costs and benefits
from these new arrangements. While even a short
library or Web searchwill uncoverliterallythou-
sandsof pages writtenon P3s, thereis a surprising
shortageof what we might call objectiveresearch
on the topic,or independentevaluationsof the suc-
cesses andfailures.Mostof whatis availablecomes
 Partnerships 137
TheEconomicsof Public-Private

fromfirmsthatearntheirincomesfromP3s or gov- collectionprovidedby municipalemployeeswould

ernment agencies charged with promoting and be anexample.Theprivatesector'sinvolvementhere
implementingsuch projects.While some of this is is limitedto selling collection trucksand gasoline
enormouslyhelpful,therecan be no doubtthatin- to the local governmentsanitationdepartment.
dependentanalysesof the strengthsandweaknesses
of P3s are warranted.6 Fora numberof goods andservicesgovernments
would be unsatisfiedwith the quantity,qualityor
distributionof theoutputsresultingfrompurelypri-
THESCOPEOFPUBLIC-PRIVATE PARTNERSHIPS vate provision,andso they take a moreactiverole.
It could be, for example,thatthereis a significant
A SimpleFramework:Tasksand General social value to a moreequal access to some goods
Policies thanfully privatemarketswouldprovide- health
The process throughwhich a projectis developed careandeducationcome to mindas possibleexam-
to creategoodsandservicesmight,forourpurposes, ples. In othercases, it maybe thatthe good cannot
be roughlybrokendownintofourprinciple"tasks":7 be providedeffectively by the marketbecause of
public good and excludabilityproblems.Here the
Task1: defininganddesigningthe project, classicexampleis nationaldefence,butroadswould
be a relatedexample.8It may also be the case that
Task2: financingthecapitalcosts of theproject, the free marketoutcome,in the presenceof signifi-
canteconomiesof scale relativeto marketsize, will
Task3: buildingthe physicalassets (e.g., road, breakdown into a monopoly,as was the expecta-
school, etc.), and tion with respectto manypublicutilities.

Task4: operatingandmaintainingthe assets in Government interventionin thesecases cancome

orderto deliverthe product/service.
One of the government'sduties is to decide to
whom these tasks shouldbe allocated;and in this
they have essentiallythreegeneralpolicy options.
Most commonly,they let free marketsdo all the
work- people earnincome (usuallyin privatela-
bourmarkets)and go to outputmarketsto buy the
goods and services they value from privatesector
sellerswho performtasks 1 to 4. The government's
role in thesecases is limitedto providingthe frame-
work laws and enforcement that make private
marketsworkwell, includingcontractlaw,criminal
law, andcompetitionlaw.
At the otherend of the spectrumis purepublic
enterprise,in which the governmentproducesthe
good or serviceitself, withno particular
privatesec-
tor involvement except perhaps through the
provisionof inputssold in standardmarkets.Refuse
in a numberof forms,differingin the allocationof
responsibilityandcontrolovertasks1 to 4, between
governmentandprivatesector.Whenit assumesall
the tasks,we have purepublicprovisionandwhen
some tasks are delegatedto the privatesector we
havevariousformsof contracting-outandP3s.
Public-PrivatePartnershipsand Optimal
PrivateversusPublicInvolvement
Even standardpublicprovisionof serviceshas tra-
ditionally involved partnershipswith the private
sector to at least a limited extent.9 However,as
mentioned,in recentyearsmanygovernmentshave
begunto considerexpandingthe use of the private
sector in the productionof public services. In the
broadestsense of the termthis is privatization,that
is, the assignment,to the privatesector,of control
over some decisionspreviouslymadeby the public
sector.10 It is common for the public sector to
performtasks 1, 2, and 4, possibly leaving task 3

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004

138 Jean-Etiennede Bettigniesand ThomasW Ross

(construction)to the privatesector.Constructionof using privatesector financingand experimenting

public buildings,for example,is usually done by
privatecontractors.1" And it is not uncommonfor
the governmentto "contract-out," refusecollection;
thatis, to put a collectioncontractout for bids and
to payfor the serviceson behalfof local citizens.In
such a case, the governmentspecifies a required
level of service, solicits bids or proposalsand se-
lects a "winner."'2Theprivatesectorproviderthen
hasconsiderablecontroloverhowtheserviceis pro-
vided: for example,what routes will be operated,
whatequipmentwill be used,whowill be employed,
etc.13
with P3s to provideroads,bridges,hospitals,air-
port terminals, schools, prisons, passenger rail
services (heavyand light rail), and waterservices,
to namesome of the mostcommon.Thesekindsof
projects,andtheprivatefundsusedto financethem,
have so dominatedthe P3 landscapethat in some
circles this arrangement
has becomethe very defi-
nitionof a P3, andthey will be our focus here.
In the next three sections, we discuss in detail
these threecharacteristicsof P3s: contracting-out,
privatefinancing,andthe bundlingof tasks.

P3s lie somewherebetweensimplecontracting-

out and a fully private marketin the spectrumof CONTRACTING-OUT: THEFOUNDATION OF P3s
private versus public involvement. The more private
relativeto public involvement,the more "private" In the last 20 years, dissatisfactionwith the costs
the public-privatepartnership. associatedwithgovernment production hasled many
governments to considerexpanded of the pri-
use
in
We suggest there are threemain characteristics vate sector the production of certain public
of thenewwaveof P3s.First,all P3s arereallyexten- services.14
sions of contracting-outto a largernumber(and
differentset) of the taskslistedabove.Thus,thecon- Constructionis the task mostoften delegatedto
tracting-out relationshipis the foundation of theP3. the privatesector, in fact it is the normin North
America.While governmentsmay retaincrews to
Thesecondmaincharacteristic has to do withthe maintain,repair,and renovatephysical facilities,
of or
"bundling" responsibilities, the allocationof seldom do they undertakelarge-scaleconstruction
two or more tasks to a unique (consortium of) projects.Whetherthe projectinvolvesthe construc-
partner(s).It is very typicalto have the same part- tionof a bridge,school,hospitalor prison,thenorm
ner in chargeof the constructionandthe operation is that privatecontractorswill do the work. It is
of a bridge, for example;indeed thatpartnermay worthrememberingthis, as it remindsus that the
well have previouslydevelopedthe design for the currentwave of P3s is not really so revolutionary
bridgeandprovidedthe financing. - the privatesector has always been engagedin
manypartsof the provisionof public services,in-
Finally,the thirdnotablecharacteristicof many cludingarchitecturalworkand construction.What
modernP3s is the allocationof the financingtask is neweris the largernumberof tasks assignedto
to the privatepartner.The recentincreasein inter- the publicsectorand the way they arebundledto-
est in public-privatepartnerships has been focused gether.Contracting-out remainsthe foundationof
on projectsinvolving a significantcapital invest- modernP3s.
ment- typicallyneededto cover the construction
costs of some new buildingor piece of infrastruc- While the experiences of governments with
ture.Thenoveltyof P3s is thegovernment's recourse contracting-out arecertainlyvaried,theevidencesug-
to privatefundsto structuretheseinvestments.Spe- geststhatit canreducecostsand/orprovideforsuperior
cifically, governmentsaroundthe worldhave been levelsof servicerelativeto publicprovision."15

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004


Ex Ante Competition
A key reasonfor the success of contracting-outat
reducing costs appearsto be competition:while
there will ultimatelybe only one providerof the
servicefor a certainperiod- andthereforeno com-
petition "in the market"- the bidding process
allowscompetition"forthe market." As pointedout
by Demsetz (1968) years ago, ex ante competition
for the projectcan replacecompetitionin the mar-
ket to forcebiddersto lowercosts, raisequalityand
be innovative.Unhappinesswiththeprivatecontrac-
tor can be punished the way the private sector
punishes:terminationfor cause, lawsuitsfor con-
tractbreach,damageto reputation,andloss of future
business,etc. This does not happenwithpublicsec-
tor provisionof the service(whereeach department
hasmonopolypowerwithinits sphereof influence).16
High-poweredIncentivesand OptimalRisk
Allocation
The otherkey reasonfor the success of contracting
at reducingcosts is incentives-related.The private
sectoris generallyregardedas havinga greaterabil-
ity to delivermoreinnovativeproductsmorequickly,
with more flexibility,and at a lower cost (not nec-
essarily at a lower price) thanks to its access to
higher-poweredincentives.17
The oft-cited claim that P3s allow for a better
allocationof risks is but an exampleof the benefits
of higher-powered incentives.The ideais thatsome
kindsof risks are best assignedto one partyor an-
other.'8 In our view, optimalrisk allocationis all
aboutincentivemanagement,partiesshouldbe ex-
posedto riskto the extenttheycanbest managethat
risk,whereby managewe meanmeasureand,through
theiractions,minimizetherisk.19If allriskwerepurely
exogenous,liketheweather,it wouldbe hardto argue
thatthereis anyadvantagein shiftingit to theprivate
sector(giventhatgovernments arelikelytohavedeeper
pockets)exceptperhapsto insurancecompanies.The
advantage to shifting,say,construction riskto thepri-
vate sectorpartneris thatbearingthis riskgives it a
strongincentiveto controlthoserisksthroughcareful
andhighqualityconstruction.20
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Partnerships 139
TheEconomicsof Public-Private
Scaleand/orLearningEconomies
In additionto ex ante competitionandoptimalallo-
cationsof risks,thereareothergoodreasonsto hire
privatecontractorsto constructfacilities.The most
importantrelates to economies of scale. Govern-
mentstypicallydo nothaveenoughworkto generate
the volumes of business needed to allow a full-
serviceconstructioncompanyto get unitcostsdown
to theirminimum,throughscale or learningecono-
mies.21 As Williamson (1979) pointed out with
referenceto the choice firmshaveto makebetween
internalandexternal(i.e., market)provisionof goods
andservices,the advantagegoes to the marketwhen
therearesignificantscaleor learningeconomiesthat
cannotbe achievedby thevolumeof businessrequired
by thebuyer(in thiscase the government).22
Contracting-outTheory,Efficiency,and
Incentives
Muchof the theoryon contracting-outhas focused
on the relationshipbetween ownershipstructure,
efficiency,and incentives,and in that sense relates
to, andformalizes,the ideasdescribedearlier.Here
we presentthe main directionsof researchon the
topic in recentyears.
Relationship-specificInvestmentsand
ContractualIncompleteness
Ex Post Inefficiencies. Considerthe design, con-
struction,and operationof a bridge, hospital, or
school.23Whatdo these projectshavein common?
Onecommonalityis thatonce theprovider(thegov-
ernmentemployeeor privatesector company)and
the customer(the governmentor taxpayer)startto
trade, that is, start to work together towardthe
completionof, say,a bridge,theyarebetteroff com-
pleting the project together than terminatingthe
relationshipandstartingto tradewithotherparties.
The reasonis that both the providerand the cus-
tomer make relationship-specificinvestmentsthat
are morevaluableif the projectis broughtto com-
pletion than if trade breaks down. The provider
invests in buildinga bridge that correspondsspe-
cifically to that particularcustomer'srequest (in
termsof location,design,equipment,timing,etc.).
140 Jean-Etiennede Bettigniesand ThomasW Ross

If the negotiationsbetween the providerand the contractualincompleteness,and his ideas, as well

customerbreakdown,theprovidermayindeedhave
troublefindinganothercustomerfor thatbridge.
The initial customeralso makes relationship-
specificinvestments(e.g., searcheffort,time,design
effort)thatareworthmorewiththecurrentprovider
thanwith anotherdesigner/builder/operator for the
bridge. The investmentto find the provider,or to
collaborateon the design, may be worthlittle if a
new providermustbe found,andthatnew provider
may have completelydifferenttechnologicalcapa-
bilities andrequirea very differentdesign.
Thus, the consequenceof relationship-specific
investmentsis the formationof a surplusfromtrade.
Transactioncosts arise because both the provider
and the customerwant to appropriatethat surplus
from trade, and the bargainingand opportunistic
behaviourthatis generatedmay in itself be costly.
Oneway to mitigatetheseso-calledex post inef-
ficiencies is to limit opportunitiesfor negotiations
andbargainingby writinglong-termcontracts.We
limit transactioncosts by reducingthe numberof
transactions.In our example,the governmentcan
mitigatetransactioncosts by writing a long-term
contractwith the (private)bridgeoperator,and by
encouraginglong-termcontractsbetweentheopera-
tor andothersuppliers,such as the designerand/or
the contractor,for example.Thisis theP3 scenario.
However,traderelationshipsareoftenverycom-
plex anduncertain.Thislevel of complexityimplies
thatfirst,it is impossibleto planfor everypotential
as those of Williamson (1975, 1979, 1985), and
Klein,CrawfordandAlchian(1978), sparkeda new
literatureon the subject.It was arguedthatbecause
of theirincompletenature,contractsmustconstantly
be revisedand/orrenegotiated as timegoes on (long-
termcontractsare infeasible),and the problemof
ex post inefficiency generated by relationship-
specific investmentscannotbe easily mitigated.
Hence when contractsare highly incomplete,
verticalintegration,by avoidingrenegotiationalto-
gether,mayofferthe best alternative.In suchcases
it maybe optimalto putthe sameparty(thegovern-
ment)in chargeof thedifferenttasks,suchas design,
financing,construction,andoperation.It avoidsthe
bargainingcost thatwouldbe generatedif the tasks
were allocatedto differentparties.Thisis the pub-
lic provisionscenario.
CrockerandMasten(1996)makethiscomparison
betweenlong-termcontractsandverticalintegration
in the contextof franchisebiddingversusregulation.
Theysummarize thechoicesveryclearlyin Figure1,
which we replicatebelow,adaptingit slightlyto fit
ourP3 versuspublicprovisioncontext.
1
FIGURE
Procurement
Optimal of Public
Services
Relationship-
specificAssets?
No Yes

contingency,andsecond,even if everycontingency
couldbe predicted,it wouldprobablybe difficultto Complex or
Uncertain
Exchange
write down these plans in a contractbetween the Environment?
customerandtheproviderthatis enforceableby law.
No Yes
In that case, long-termcontractssuch as the ones
just describedare less helpfulbecausethey cannot
be madeto bindin somecircumstances: we say that SpotMarkets Contracts Vertical
Long-term Integration
the contractsareincomplete.Coase(1937) was the [P3] [Public
Provision]
first to recognize the economic consequencesof

CANADIAN PUBLIC POLICY - ANALYSE DE POLiTIQUES, VOL. XXX, NO. 2 2004


Withoutrelationship-specificinvestments,there
are no transactioncosts and spot marketprovision
is thebettersolution:it allowsmoreflexibilityrela-
tive to long-term contracts and it permits the
efficienciesassociatedwithcompetitionandprivate
provision.A good exampleof this would be food
stamps:the governmentprovidesa product(food)
that requiresno specific investment,via the spot
market(supermarkets).
When there are switching costs, two sub-
possibilitiesarise:long-termcontractsofferthebest
alternativewhenthe relationshipsremainrelatively
simple (e.g., building a bridge) such that writing
effective contractsis possible,but verticalintegra-
tion is sometimes necessary when transactional
complexitiesmake ex post inefficienciestoo large
(e.g., perhaps,some types of healthcare).
Ex Ante Inefficiencies. Note that although the
theoryon ex post inefficienciesprovidespowerful
insightsinto the advantagesof long-termcontracts
relativeto spot markets,andof integrationrelative
to long-termcontracts,respectively(the mitigation
and/oreliminationof ex post transactioncosts), it
remainsmore vague as to their disadvantages(in-
flexibility,bureaucracy).The following discussion
of ex ante inefficienciesshouldclarifythese issues
by formalizingthe trade-offbetweenbenefits and
costs for each organizationalstructure.
Recall that with relationship-specific invest-
ments, a situationof bilateralmonopolyarises, in
whicha surplusfromtradeis created;andthatwhen
contractsareincomplete,the tradingpartiesbehave
opportunistically in theirattemptto appropriate that
surplus.The abilityto behaveopportunistically de-
pends greatly on ex post bargainingpower, which
itself dependson theparty'soutsidealternative,that
is, thatparty'spayoffin theeventnegotiationsbreak
down.Whena partyhas an attractive outsidealterna-
tiverelativeto a tradingpartner,he orsheis in a better
bargainingposition,sufferinga smallerpenaltyfor
leavingtherelationship thandoes the otherparty.
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Partnerships 141
TheEconomicsof Public-Private
In the late 1980s GrossmanandHart(1986) and
HartandMoore(1990) gave new impetusto the lit-
eratureby underliningthe importanceof property
rights.Propertyrightsover an asset conferex post
bargainingpower,because the owner of the asset
keeps control over the asset, and can preventthe
otherpartyfromusingit, shouldnegotiationsbreak
down.In otherwords,propertyrightsincreaseone's
outside alternativerelativeto thatof one's trading
partner,andthatputsone in a betterbargainingpo-
sition. Consideragainthe relationshipbetweenthe
customer (the government)and the providerin-
volved in the development of a bridge. If the
provideris anindependentfirm/consortium (thepri-
vate sector) trading at arm's length with the
government(e.g., P3), he or she has some bargain-
ing powerin renegotiationbecausetheykeepaccess
to assetsif tradebreaksdown,andthushave an at-
tractiveoutsidealternative.In contrast,if the assets
usedby the providerareownedby the government,
the publicsectoressentiallybuildsthe bridge(pub-
lic provision), with the provider as government
employee.In case of disagreementthe government
canjust fire the individual,andthus the provider's
outsidealternativein thatcase is muchless attrac-
tive,andhe orshe is in a weakerbargainingposition.
Bargainingpower in renegotiation,and hence
asset ownership,is importantbecauseit affectsin-
vestmentincentives.The more ex post bargaining
powerthe provideranticipates,the less likely he or
she is to be "held-up,"the largerthe fractionof the
surpluscreatedtheywill be ableto appropriate, and
thegreaterincentivetheyhaveto makerelationship-
specific investmentsin the first place. Of course,
morebargainingpowerto the providermeansless
bargainingpowerto the government,and thus less
incentivesand less investmentby the public sector
customer.Thus,whenthe governmentchoosesa P3
contractwith a privateproviderfor the designand/
or constructionof a bridgeinsteadof publicprovi-
sion, it transferspropertyrights and bargaining
powerto the provider.This increasesthe provider's
incentivesto invest,butreducesits own incentives.
142 Jean-Etiennede Bettigniesand ThomasW Ross
The insight of Grossmanand Hart (1986) and
HartandMoore(1990) is thatpropertyrightsover
an asset should be allocated to the agent whose
marginalproductof ex ante investmentis the high-
est. The governmentshould use a private sector
providerfor a particulartask (e.g., design, financ-
ing, construction,or serviceprovisionfora hospital)
only if the marginalefficiencyof the providerinto
this"relationship" is higherthanthatof thecustomer
(government), because the transferleads to a net
efficiency improvement.
Public versus Private Ownership
In the descriptionof the literatureon incomplete
contractsofferedearlier,we adaptedthe theoryto
the relationshipbetween the governmentand the
provider.These models, however,were originally
developedto explaintheboundariesof privatefirms.
In the past few years, economistshave startedto
applyincompletecontracttheorymorespecifically
to policy surroundingpublicversusprivateowner-
ship.
Schmidt(1996) was amongthe first to investi-
gate the trade-off between public and private
ownershipin an incompletecontractsframework.
His model is based on the following assumptions:
(i) the managercan exertan unobservableeffortto
reduceproductioncosts, (ii) the managerreceivesa
privatebenefit from production,and (iii) property
rights confer better information:the government
knows aboutcosts andprofitsin the case of public
provision,but not in the case of privateprovision.
These assumptionsyield two interestingresults.
First,with privateprovision,the associatedlack
of informationenablesthe governmentto credibly
commit to an incentive scheme for the manager.
Based on a revelationgame, this incentivescheme
punishes the managerwith low productionwhen
productioncost is revealedto be high. In contrast,
with publicprovision,the governmentcannotcred-
ibly commitnot to renegeon productiondecisions,
and thus the managerhas lowerincentivesandex-
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
ertslowereffort.Publicprovisionthusleadsto lower
productiveefficiency.
Second,withprivateprovision,thegovernment's
commitmentto cut productionwhencosts are high
leads to too low a level of productioncomparedto
public provision. Public provision thus leads to
higherallocativeefficiency. Schmidtthus defines
the trade-offbetweenpublicandprivateownership
as follows: althoughprivateprovision generates
higherproductiveefficiency,publicprovisiongen-
eratesgreaterallocativeefficiency.
Hart,Schleiferand Vishny(1997) focus on the
muchdebatedtrade-offbetweenlowercost andlow-
ering quality of service provision. Indeed, they
providethe formalfoundationfor the argumentthat
privateprovisionmaylead to moreefficiencyin re-
ducingthecostof serviceprovisionrelativeto public
provision,butthismustbe tradedoff againsta lower
qualityof service.
Theirresulthinges on two assumptions:incom-
plete contractsand a positiverelationshipbetween
cost of serviceprovisionandqualityof service;that
is, loweringcost has a negativeeffect on the quality
of the service provided.The incompletecontracts
assumptionmakesownershipimportant: privatepro-
vision impliesthattheproviderownsits production
technologyandthereforehasmorebargainingpower
relativeto governmentthanif the service was pro-
vided by a governmentemployee. Thus, if the
serviceprovideris the privatesector,it will have a
greaterincentiveto investin cost reductionex ante,
and in equilibriumservice is providedat a lower
cost by the privatesector.On the other hand, the
privatesectorfails to internalizethe negativeeffect
thatcost reductionhason servicequality,andthere-
fore has too muchincentiveto reducecosts, to the
detrimentof servicequality.In Hart,Schleiferand
Vishny(1997), the privatesector has more incen-
tive to producemoreefficiently,butso muchso that
it tries to "cutcorners,"which affects quality.The
choicebetweenprivateandpublicprovisiondepends

on the importanceof productionefficiencyrelative
to this
"corner-cutting."'24
The Special Case of Public Goods
Besley andGhatak(2001) focus on the provisionof
a public good. They ask whether a public good
shouldbe providedby the publicsector,orby a pri-
vateentitysuchas a non-governmental organization
(NGO),for example.The two partiesinvest in the
productionof the good and negotiateover the sur-
plus created.In the simplestframework providedby
Grossman andHart(1986)andHartandMoore(1990),
if negotiationsbreakdown,theownergets someben-
efitwhiletheotherpartygetsnothing.Becauseof that,
theownerof theassethasmorebargaining powerand
higher incentives,and ownershipto the
transferring
agent with highestmarginalefficiencyin investment
maximizesthe totalsurplusandis optimal.
When the good is public, however,both parties
enjoysomebenefitif negotiationsbreakdown.Even
if tradebreaksdownbetweentheNGOandthe gov-
ernmentand the NGO is no longerinvolvedin the
developmentof the good, it still gets an "alterna-
tive"benefit, due to the publicnatureof the good.
Forexample,the NGOwithaneducationalmandate
mayget a benefitfromthe creationof a new school
even if it is not involvedwith its operation.
Besley and Ghatakdevelop a model where an
increasein the alternativebenefit(dueto investment
by one or bothpartiesex ante)raisesthe caringpar-
ty's valuationof that alternativebenefit morethan
the non-caringparty'svaluation.Consequently,an
increasein the alternativebenefitimprovesthe car-
ing party'sbargainingpositionandexpectedpayoff,
relativeto the partythatcaresless, whose bargain-
ing positionandexpectedpayoffhaveworsened.To
maximizethe total benefitin equilibrium,the allo-
cation of propertyrights must thereforemaximize
the marginalimpactof investmenton the alterna-
tive benefitfor the morecaringparty,andminimize
the marginalimpactof investmenton the alterna-
tive benefitfor the least caringparty.
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Partnerships 143
TheEconomicsof Public-Private
The key assumptionin this model is thatgiving
ownershipto a partymaximizesits marginalprod-
uct of investmenton the alternativebenefit, and
minimizesthe otherparty'smarginalproductof in-
vestmenton the alternativebenefit.In otherwords,
"apartof the returnof the investmentof a playeris
embodiedin humancapitalandcannotbe realized
if theindividualis fired"thatis, if negotiationsbreak
downandtheindividualdoes notownthe asset.
It thenfollowsthatownershipshouldbe allocated
to the partywith the highestvaluation.If the NGO
values the school more than the government,it
shouldbe grantedtheownershiprightto providethe
service.An interestingimplicationof the model is
that the efficiency result arguedby Grossmanand
HartandHartandMooremay not hold with public
goods. Indeed,if the governmentvaluesthe public
good morethanthe privateprovider,it is optimalto
havepublicprovisionevenif the governmentis less
efficientthanthe privateprovider.
COMPLEMENTARITIES
ACROSSTASKS
DelegatingDesignand/orOperationsto the
PrivateBuilder
As mentionedpreviously,one of the key character-
istics of P3s is that responsibilityfor two or more
tasksmaybe given to the samepartner.In particu-
lar, the design of the projectpriorto construction,
and/orthe responsibilityfor operationand service
provisionafterconstruction,maybe allocatedto the
builder.
The advantagesof privatizingtasks 1 and4 may
be similarto those associatedwith contracting-out
construction,whichweredescribedearlier.Consider
scale and/orlearningeconomies,for example.It is
certainlytruethata numberof P3s (e.g., highways
withnewelectronictolling)involveprojectsthatare
novel for the governmentin questionbut may be
familiarto a largemultinationalcontractorthathas
workedon similarprojectsin otherjurisdictions.25
144 Jean-Etiennede Bettigniesand ThomasW Ross
In sucha case, the governmentcan chooseto payto
be educatedandthenperformthe operationsitself,
or it canjust contractthatserviceout. Contracting-
out will be particularlyattractiveundertwo condi-
tions: (i) when the governmentwill not be able to
amortizethe expenseof the educationacrossmulti-
ple projects;and (ii) when the operationsactivity
will benefitfromongoingresearchanddevelopment
thatcannotbe effectivelyreplicatedby government.
Anotherpossibleadvantagefromhandingdesign
and/oroperationsover to the privatesectorderives
fromthe greaterefficienciesthatmaybe attainable
withprivatesectorproduction,throughex antecom-
petition,improvedincentives,andthe presenceof a
marketfor corporatecontrol.26The extensivelit-
erature,referredto above, comparingpublic and
private provision of services and the effects of
contracting-out,has generallyfoundthattheprivate
sector will deliver services at a lower cost. How-
ever, the most commonly cited advantage of
allocating design and/oroperationto the builder
derives from complementaritiesassociated with
combiningdesign,construction,financing,andop-
erationwithinone firm(or consortium).The ideais
that by combiningthese functions,the consortium
will have an incentiveto minimizethe full lifetime
costs associatedwith providingthe service.27This
may involve spendingmore in constructionto re-
duce maintenanceor operationcosts later,an effect
the consortiumcan internalize.
There is likely to be a certain technological
complementarityor economy of scope between
buildingand designing,and betweenbuildingand
service provision.28The complementarityis en-
hancedby the incentiveadvantagesof combining
these tasks- if you have to build the projectand
your reputationdependsin part on the qualityof
the outcome,you have a strongincentiveto see it
well designed.29 Similarly,if the privatepartner
doing the constructionis also going to operateand
maintainthe facility,it will be bearingall the costs
of the serviceandso will havean incentiveto mini-
mize those costs. It makessense in a case like this
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
to bringthispartnerintothe designprocessas well,
since otherwiseit risksliving with a poordesign.
Contrastthis situationwith the one in whichthe
governmentdesigns, finances, and arrangesthe
buildingof the facility,but lets someoneelse oper-
ate andmaintainit. The facilitycanbe builtso as to
requirehigheror lowerlevels of maintenanceandit
is far from clear that with decision-makingsepa-
ratedbetweenthepartiesthatefficientdecisionswill
be taken.Construction firmsbiddingon thecontract
to buildthe facility,in an effortto appearto be pro-
viding their services at lower costs, will not
necessarilyadvocatefor more durableand expen-
sive construction.If, on the other hand, they are
biddingto providethe servicesthey havean incen-
tive to proposea designandplanfor construction to
minimizethe costsof the serviceoverthefull life of
the facility(orat leastthelengthof thecontract).30
PrivatizingOperationand the Government's
Loss of Control
Operatingthe asset and providingthe service are
the publicface of a P3: the highlyvisible attributes
to whichpeoplemost frequentlyrespond.
The majorconcernof opponentsof contracting-
out in general, and P3s in particular,is typically
aboutthe loss of controlassociatedwithgivingpri-
vate providerscertaincontractualrights.The fear
is thatthe perfectcontractcan neverbe writtenand
that, even if it could, performancecannotbe per-
fectly monitored.Twonegativeimplicationsfollow:
first,the incompletenessmeansthatwhenchanging
circumstancesnecessitatechangesin the behaviour
of the privatefirm, this will have to be negotiated
(in a smallnumbersbargainingsituation,i.e., with-
outbenefitof competition)andthiscouldbe costly;
andsecond,theimperfectmonitoringmeansthatthe
privatepartnercan cheat on qualityor some other
non-contractualelement.31It is concernover the
qualityof servicesthatwill be providedby the pri-
vatesectorin say,jails, hospitalsor schools,thatis
the majorhurdleP3s haveto overcometo gainpub-
lic confidencein theirabilityto meetpublicneeds.

The challenge,when the privatesectoris to use
the facility to provide the service, is in carefully
specifyingthe characteristicsof the servicethatthe
governmentcares aboutso that thereis no misun-
derstanding(ordeliberateexploitationof incomplete
contracts)betweentheparties.As withmanyaspects
of P3s, the contractingchallengeshere are signifi-
cant - importantcharacteristicsof servicequality
must be measuredand verifiablestandardsof ac-
ceptableperformanceestablished.32Forthisreason
it is notsurprisingto see thatmanyjurisdictionshave
createdspecializedagenciesto reviewproposalsand
lay out contracttermsfor P3s. These groupsoften
functionas within-government consultantson P3s,
andas repositoriesof knowledgeandexperiencethat
provide governmentswith the skills they need to
structureP3s to theirmaximumbenefit.
TheoreticalLiteratureon P3s as the
Privatizationof Both Constructionand
Operation
TherecentresearchdealingspecificallywithP3shas
definedthem,really,as thedelegationof twoormore
to the privatesector.Herewe re-
tasks, "bundling,"
view the mainarticlesandpresenttheirkey results.
Bundlingand IncompleteContracting
In a recent article, Hart (2003) adaptedthe Hart,
SchleiferandVishny(1997) model to analyzeP3s
specifically.The governmentis concernedwith the
buildingandthe operationof an asset, say a hospi-
tal or a prison.The buildercan maketwo types of
investmentsat the time of constructionwhich af-
fect the operation of the asset. The productive
investmentincreasesthebenefitandreducesthecost
of operation(e.g., investmentin buildingquality),
while the unproductiveinvestmentreducesoperat-
ing cost but also its benefit (e.g., investmentin
"corner-cutting,"similar to Hart, Schleifer and
Vishny).33With "conventionalprovision,"the gov-
ernmentcontractsseparatelythe buildingand then
the operationof the prison.Thebuilderis thuspaid
beforethe fruitof his two investmentsarerealized.
Anticipatingthis, the builderinvestsnothingin the
first place. In contrast,with a P3, the government
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Partnerships 145
TheEconomicsof Public-Private
contractswith the builderto both constructandop-
erate the prison.34The builderanticipateshe will
be able to reapsome benefitsfrominvesting- in
termsof lower operatingcosts - and thus makes
positive investmentsin both building quality and
corner-cutting.Therefore,relativeto P3s, conven-
tional provisionleads to more underinvestment in
productive effortbuildingquality,while P3s lead to
overinvestmentsin corner-cutting.Hartconcludes
that P3s may be optimal when building quality
cannotbe well specifiedandcorner-cuttinginvest-
mentsarerelativelyeasy to monitor,becausein that
case both overinvestmentsin corner-cuttingand
underinvestment in building quality are relatively
low.
Bundlingand AsymmetricInformation
In contrastwith the previousmodels,which started
froman incompletecontractsframework,the most
recentpaperon P3s takes a completecontracting
approachwhereagencyproblemsbetweenthe cus-
tomer(government)andthe provider(the agent,the
privatesector) stem from asymmetricinformation
and non-observabilityof effort. Bentz, Groutand
Halonen(2002) considerthe constructionandserv-
ice provisionrelatedto a productsuch as a school.
They analyzewhethera governmentshouldopt for
"conventional delivery"- in whichcase it contracts
with a builder,takes possessionof the school, and
then writes a separatecontractwith a service pro-
vider- or for a P3, in whichcase thereis a unique
contractbetween the governmentand a "consor-
tium"thatbuildsandmanagesthe school.
Bentz,GroutandHalonenassumethatthebuilder
canexerteffortto improveefficiencyof servicepro-
vision, andthatthis efficiencyis observableonly to
the serviceproviderbutnot to the government.With
P3s, thereis a uniquecontractand the model sim-
plifies to a standardadverse selection set-up in
which the builder/serviceprovideris induced to
truthfullyreveal whether service provision effi-
ciencyis high or low. The informationrentgiven to
the agentto inducetruth-tellingalso generatesin-
centivesto exerteffortat thebuildingstage,andthus
146 Jean-Etiennede Bettigniesand ThomasW.Ross
providingincentivesis relativelycheapwith P3: it
allows the governmentto "hit two birds with one
stone."Conventionaldelivery does not have this
advantageand thereforethe paymentmadeby the
governmentto inducehigheffortis higherwithcon-
ventionaldelivery.
On the otherhand,compensationhas to be paid
less frequentlywithconventionaldeliverythanwith
P3. Indeedefficiencymaybe high due to the build-
er's effort, or simply due to the forces of nature.
Withconventionaldelivery,the agent/buildermust
be compensatedonly whenefforthas beenexerted,
whereaswithP3s the paymentfromthe government
is madewheneverefficiencyis revealedto be high,
whichincludesthe case wherehighefficiencyis the
resultof nature.Thusis the trade-offbetweencon-
ventional delivery and P3s in this paper:
compensationto theagentis higherbutless frequent
in the formerthanin the latter.
PRIVATEFINANCINGAND THETRUE COST OF
CAPITAL
Traditionally, governmentsfinancedpublicprojects
themselves, either fromcurrenttax revenuesor by
borrowing.Perhapsthe most strikingaspectof the
new wave of P3s is the extentto which the financ-
ing is being handledby the privatesector.Indeed,
one of the most frequentreasonsgovernmentsem-
ploy to justify theiruse of P3s is thatthey arecash-
strappedand too debt-ladedalready,and therefore
need an infusionof capitalfromthe privatesector
if the projectis to proceed.While almostcertainly
true for many underdeveloped and developing
economies (where P3s have been used for some
time), the argumentis made more and more fre-
quentlyby governmentsin developedeconomiesas
well.35
Criticsof P3s ask how it can be betterto let the
privatesector finance projectswhen governments
(at least thosein Canadaandmostof the developed
world) can borrowat lower rates of interestthan
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
privatefirms.They arguethat such P3s are a trick
employedby governmentswantingto fool taxpay-
ers into thinkingthey are holding down levels of
publicdebtwhilecontinuingto offerdesiredservices.
We agreethatthe use of P3s to "hide"debtis a
concern.Herewejust makethe fairlyobviouspoint
that undercertainassumptionsthereis a financial
equivalencebetween a policy in which a govern-
mentborrowsto pay for a projectand thenrepays
the loan over some periodand a policy in which a
government lets a privatepartypayforandconstruct
the asset and then pays that party back through
"lease"paymentsoverseveralyears.In bothcases,
the governmentgets the benefitof using someone
else's money (the lender'sor the privatedevelop-
er's)to secureconstruction,andthenpaysit off over
time. Dependingon how the accountingis done,
however,the P3 may not show up as debt on the
government'sbooks and for governmentslooking
to convincetaxpayersthatthey are not overspend-
ing, this may be a good thing,if the taxpayerscan
be so fooled.36
However,thereare a numberof reasonswhy it
may make sense for the financingto be done by
parties other than the government.A careful re-
sponse addressestwo points:first, that it is not at
all clearthatgovernments canborrowmorecheaply;
and second, that there may be complementarities
betweenfinancingandthe othertaskssuch thatwe
shouldlookatthecombinedcostsof havingthosetasks
performed, notthecost of financingin isolation.
Canthe GovernmentBorrowMore Cheaply?
To begin, we note that a comparisonbetweenthe
borrowingrates charged to governmentsand to
privatepartnersis notnecessarilycomparingapples
with apples,as the privateborroweris acquiringa
putoptionwith its loan andthis mustcost it some-
thing.To see this, assumethatbecauseof its very
low probabilityof bankruptcy, the governmentcan
borrowat the risk-freerateof interest,say this is 5
percentover 20 years.If a privateborrowerhadan
equallylow probabilityof bankruptcy it wouldalso

be able to borrowat 5 percent,but in fact over the
chance
courseof 20 yearsthereis a not-insignificant
it will be unableto meet its debtobligations.Thus,
a loan contractwith this privateborrower,say at 7
percent,is actuallya combinationof a loan plus an
option to "put"the remainingportionof the debt
backto the originallender.
The importantobservationhere is thatthe gov-
ernmentdoes not get this putoptionwhenit pays 5
percent,it must repay the loan in full, no matter
what.This is not to say thatthe cost of borrowing
has to be identicalwhenwe takethe putoptioninto
account,it is just to point out that the listed rate
exaggeratesthe difference.37
The secondpointwe wouldmakeaboutthe rates
at which governmentand privatepartiescan bor-
row,is thatwith a solid, long-termcontractfroma
governmentbuyera privateborrowercanmostlikely
securea very good rate fromprivatelenders.Here
thegovernment's reliabilityas a buyersubstitutesfor
its reliabilityas a borrower,with the resultthatthe
rateat whichtheprivatepartycanborrowis verylow.
Third,the privateborroweris able to deductin-
terestpaymentsandso reduceits tax burden.While
some of this savingmayjust be a transferfromthe
very governmentwith whichit is partnering,some
could be fromotherlevels of government.For ex-
ample,in Canadathe tax savingscome, in part,at
the expenseof the federaltreasury,while the public
sector partnermightbe a provincialor local gov-
ernment.While from the standpointof national
wealththese arenot real savingsin resources,from
the perspectiveof the partners(includingthe pro-
vincialor local government),someportionsof them
are,andtheyfunctionas a formof subsidyfromthe
other level of governmentavailable only if the
projectis privatelyfinanced.
Fourth,when we recognize that governments,
particularlysubnational(e.g., provincial)ones, can
get themselves into serious financial troubleand
even possibly face bankruptcy,we know thatthey
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
Partnerships 147
TheEconomicsof Public-Private
will often not be able to borrowat the risk-free
rate.38 Importantly,they may face an upward-
sloping supplyof capitalcurvesuch thatthe more
they borrowthe higherthe interestrate they must
pay. For example,as a provincialgovernmentin-
creases borrowingit runs the risk of having its
debt-ratingdowngradedand having to pay higher
rates on all of its borrowing.The implicationis a
familiarone frommonopsonytheory- the cost of
borrowingfor the next projectis higherthanjust
the interestrate you pay for that projectif it also
increasesthe rate you pay for all your otherbor-
rowing.For a governmentborrowingconsiderable
sumsof moneyregularly,thechanceof a downgrade
leadingto theneedto payevena quarterpercentage
point more is a very serious matter.Thus, we can
have a situationin which even if the interestrate
chargedto the governmentborrowingfor the next
projectis lowerthanthatwhicha privatesectorpart-
ner wouldhave to pay, the "full"marginalcost to
the governmentcould be muchhigher.
We concludefromthis reviewof the issues that
it is not at all clearthatthe governmentwill be able
to borrowat a lowercost thanthe privatesector.A
full evaluationof therelativecosts will haveto con-
sidersuchfactorsas: (i) the credit-worthiness of the
private borrower andthe offered
protections in its con-
tractwiththe publicsectorpartner;(ii) the extentto
whichtaxsavingsmaycomefromotherlevelsof gov-
ernment;and(iii) the degreeto whichthe supplyof
fundsto thepublicsectorborrower is upwardsloping.
BetweenFinancingand
Complementarities
OtherTasks
Possibly moreimportantthanthe relativecosts of
publicversusprivatesectorborrowingaretheeffects
thatbeingthedebtorhason one'sincentivesto high-
level performance.39It is verylikely thattherewill
be importantcomplementaritiesassociated with
combiningthe financingtask with the construction
andpossiblyalso theoperation/maintenance task.40
If a privatepartnerchargedwithconstructingthe
facility mustalso provideits own financing,it will
148 Jean-Etiennede Bettigniesand ThomasW Ross
sufferthe costs of delays. Since, of all the parties,
the builderhas the greatestcontrolover the time-
to-completion,this provides strongincentivesfor
the builderto finish on time and on budget.While
governmentscan also provokedelays,throughper-
mitting(e.g., environmental, zoning,etc.) problems
and design changes, the public sector decision-
makers are so far removedfrom their principals
(taxpayers)that whetheror not the governmentis
providingthefinancingmaynotmatterto them.Add
to thisthefactthatinordinatedelayscreatedby gov-
ernmentsmightgive the privatepartnerthe rightto
recoverdamagesand it would not appearthat any
strongincentiveloss is felt on the governmentside
by movingfinancingto the privatepartner.41
SUMMARY ANDDISCUSSION:
LESSONS
LEARNEDTOTHISPOINTANDQUESTIONS
FOR
FUTURE
RESEARCH
Our review of the relevanttheory and experience
has suggested a numberof lessons regardingthe
conditionsunderwhich P3s become a particularly
desirablealternativeto traditionalmethodsfor the
provisionof public services. To briefly repeatthe
most significanthere:42
Ex ante competition. A substantialfractionof
thebenefitsfromprivateprovisioncomesfrommar-
shalling the pro-efficiencyforces of competition.
Since the ultimateproviderof any serviceswill al-
most certainly become a monopolist, this
competitionwill have to be ex ante - at the bid-
dingstage.If therearenotenoughcompetentbidders
or biddingconsortiato makethe processcompeti-
tive, thereis less of a guaranteethattaxpayerswill
get value for money.43
Scarce skills. In many cases the privatesector
will have skills not availablein the publicsector.If
these skills will be requiredthroughoutthe life of
the projectand it is hardto separatethe provision
of these skills fromthe operationof the project,the
governmentmay need to allocate these tasks to a
CANADIANPUBLICPOLICY- ANALYSEDEPOLITIQUES,
VOL.XXX,NO. 2 2004
privatepartnerwho not only has the skills, but (be-
cause of its "ownership"of the project)also the
incentiveto performat a high level.44
Poor labour relations. Wherethe publicsector
labour-management environmenthas not produced
efficientandflexiblelabour
an appropriately-skilled,
force,the privatesector(againthroughthe forcesof
competition)mayofferconsiderableadvantages.
Innovation.Whenthe projectcalls for innova-
tive thinkingandnew approaches,mostwouldturn
to privateproviders.Of course, it is possible that
only somepartsof the project,say the architecture,
needbe innovative.In such a case it maybe best to
contractout only thatpart.The extentto whichthe
whole projectshouldbe a P3 will depend,in part,
on thecomplementarities betweenthe tasks(see the
pointson complementarities).
Risks. Whenmost of the majorrisks are things
the privatesectorcan manageas well or betterthan
the public sector,P3s become moreattractive.For
example,construction-delay risk is somethingthat
the contractorcan managebetter than the public
partneranda P3 in which the contractor(or a con-
sortiumpartner)also becomesthe operatorgives it
the incentiveto minimize such risk. On the other
hand,"politicalrisk"is bettermanagedby the pub-
lic sector.
Economies of scale. If the privateprovidercan
take advantageof economiesof scale (andperhaps
scope)fromtheoperationof similarprojectsin other
(perhapsnearby)jurisdictions,the P3 option be-
comes more attractive.45
Observabilityand measurabilityof quality.
Muchof the oppositionto privatesectorprovision
of publicservicesrevolvesaroundconcernsthatthe
qualityof servicewill fall. Inorderto protectagainst
such quality erosion, the partnershipagreement
shouldspecify the requiredquality,providefor the
measurementand verificationof quality,and pro-
vide for enforcementof thecontract'srequirements.

In some cases, however,it will be very difficultto
define, measure,and verify qualitylevels, making
the privateparticipationproblematic.
Complementarities. When physical facilities
suchas bridgesor buildingsneed to be constructed,
it is prettymuchstandardpracticefor governments
to turnto privatecontractorsto do the work,taking
advantageof their economies of scale. In some
cases, the constructionis the only task contracted
out, but when there are strong complementarities
with other tasks it becomes efficient to have one
provider(or tightlyorganizedconsortium)respon-
sible for the set of connectedtasks. This is most
frequentlyobservedwith the design task (or parts
of it) tied to the construction,butincreasinglyother
complementarities are being recognized.
Constraints on public sector borrowing. We
have seen thatif furtherborrowingrisks a deterio-
rationof a government'screditrating,the marginal
cost of borrowingcanbecomeveryhigh.Inthiscase,
allocatingthe financingtasks to the privatesector,
which might face a lower marginalborrowingrate
(even thoughits averageborrowingrate might be
higher),maylowerborrowingcosts. Casesin which
thegovernmentsimplycannotborrowat all (as with
some developingcountriescarryingenormousdebt
loads) are obvious,if extreme,examples.
While we would arguethat partnershipsshould
be embracedonly when they allow governmentsto
provideservices of an acceptablequalityat lower
other- sometimesless
cost to taxpayers/consumers,
noble- objectivesare frequentlyattributedto gov-
ernmentsadoptingP3programs.Itmaybe argued,for
example,thatP3s area wayforgovernmentsto avoid
public sector labourunions, to move debt off the
government'sbalance sheet, to hide information
fromthe public,or to deflect blame.46
Despite this learning there is much we do not
knowaboutthe optimaldesign of P3s andtheirtrue
efficiencybenefitsor costs. To stimulatefurtherre-
search in this importantarea we suggest a few
CANADIAN
PUBLIC
POLICY
Partnerships 149
TheEconomicsof Public-Private
importantquestionswhich we feel warrantatten-
tion.Somearedirectedat solidifyingourconfidence
of the lessons alreadydiscussed,otherspush into
newerareas.
First,thereis considerableexperiencewith con-
tracting-outin Canadaand elsewhere; does this
experiencesupportthe theorydescribedin this pa-
per? Then a similar question must be asked for
completedP3s, wherethereis muchless independ-
ent research.
Second,whenis the cost of borrowing,properly
evaluated,trulylower for the publicsector?A full
analysisherewouldhaveto considerelementssuch
as: (i) tax issues andtax shiftingbetweenlevels of
government;(ii) the marginalversus averagecost
of borrowingfor governments;(iii) the valueof the
put option;and(iv) bankruptcycosts.
Finally,moredetailedmodellingof the basic P3
trade-off- that is, with a P3 structurethe public
sectorgets greaterefficiencybutexercisesless con-
trol - could provideadditionalinsightsaboutthe
conditionsunderwhichthe P3 will be thepreferred
approachto publicservice provision.
SupportersclaimthatP3s representa trueorgani-
zational innovation for the efficient delivery of
public services. Opponentsarguethat they are an
ideologicallydrivenplanto reducewages to public
sector workers;one that threatensthe quality of
public services citizens have come to expect from
theirgovernments.It is time for moreindependent
researchto determinethe truebenefitsandcosts of
public-privatepartnerships.
NOTES
Theauthorswouldlike to thankNeil Alexander, Tony
Boardman, RonGiammarino, NicholasHann,Robert
Helsley,TsurSomervilleandparticipants
attheUBCCen-
tre for the Studyof Government andbusinessPublic
PolicyLuncheon (23April2003)forhelpfuldiscussions.
Very usefulcomments andguidancewerealsoprovided
- ANALYSE
DEPOLITIQUES,
VOL.XXX,NO.2 2004
150 Jean-Etiennede Bettigniesand ThomasW Ross
by two anonymousrefereesand the editor.The very ca-
pable researchassistanceprovidedby JenniferNg and
Ann-BrittEverettand the researchsupportfromthe So-
cial SciencesandHumanitiesResearchCouncilof Canada
and the UBC Centrefor the Study of Governmentand
Businessare gratefullyacknowledged.
'Two of the more representativedefinitions:(i) "A
public-privatepartnership[is] a cooperativeventurebe-
tweenthepublicandprivatesectors,builton theexpertise
of each partner,that best meets clearly defined public
needs throughthe appropriateallocation of resources,
risks andrewards"(CanadianCouncilfor PublicPrivate
Partnerships).(ii) "Theterm"public-privatepartnerships"
has taken on a very broadmeaning.The key element,
however,is theexistenceof a 'partnership'style approach
to the provisionof infrastructureas opposedto an arm's-
length 'supplier'relationship... a P3 involvesa sharing
of risk, responsibilityand reward,and is undertakenin
those circumstanceswhen thereis valuefor moneyben-
efit to the taxpayers"(BC. Ministry of Finance and
CorporateRelations1996, 8).
2Itis worthnotingthatthe rewardsneed not be meas-
ured in direct profits. Some "private"partnersmay be
enterpriseswhichmeasurerewardsin terms
not-for-profit
otherthandirectprofits.For example,a numberof air-
port authorities in Canada today are operated as
not-for-profitcorporationsin "partnership"
with various
governmentsand governmentagencies (e.g., Transport
Canada).
3Undersome definitions,regulatedprivatelyowned
utilities(e.g., electricity)mightbe seen as P3s, or at least
as examplesof an ASD.
4See, for example, the informationprovidedon the
Web site of the Public-PrivatePartnershipOffice of In-
dustry Canada, http://strategis.ic.gc.ca/epic/internet/ considerableliteraturecomparingthecosts of publicver-
inpupr-dpr.nsf/vwGeneratedlnterE/Home
5Forexample,theUnitedKingdomcreated"Partnerships
UK"in 1999,BritishColumbiacreatedtheCrowncorpora-
tion, "Partnerships BC" in 2002, and Ontariocreateda
specialagency"Ontario SuperBuildCorporation" in 1999.
6Anumberof governmentauditorshaveproducedvery
useful reviewsof P3s in theirjurisdictions.The UK of-
fice is particularlystrongin this regard.See also Grout of the largestUS cities;andDombergerandJensen(1997)
(1997) for an excellent"economic"accountof P3s in the
UnitedKingdom.A usefulcollectionof paperson public
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
is containedin Rosenau(2000).
policy partnerships
7A complementary discussionfocusedon P3s for in-
is foundin DanielsandTrebilcock(1996).
frastructure
8Withthe abilityto costlessly assess tolls for roador
bridgeuse, these problemsneed not arise. However,at
leastuntilrecently,thecost of collectingtolls in termsof
manpower/administration and lost time to travellerswas
substantial.
91fwhatthe public sectoris buyingis a moreor less
standardproduct,buying constructionservices is not
reallydifferentfrombuyingoffice suppliesin the regular
market,with the implicationthatthe term"partnership"
is probablynot appropriate.
'00f course,if it is a new service not previouslyof-
feredby governmentit is privatizationonly in the sense
thatit involvesgreaterprivatesectordecision-making than
the publicenterprisealternative.
"In some cases, the public sector may even do the
construction:some governmentshave road crews for
buildingand maintainingroads,for example,and many
will havecrewscapableof at least small-scaleconstruc-
tion andrenovationprojects.
'2Thesurveys, for Americanlarge cities by Dilger,
MoffettandStruyk(1997) andfor BritishColumbiamu-
nicipalitiesby McDavidand Clemens(1995) show that
themostcommonlycontracted-out servicesinclude:solid
waste collection,vehicle towing,streetrepair,janitorial
services,andlegal services.
31Inprinciple,all of these could be specified in the
contractwith the sponsoringgovernment,but certainly
some decisionswill remainwith the privateprovider.
"While still not withoutsome controversy,thereis a
sus privateprovisionof goodsandservices,andthe mass
of evidencewouldseem to suggestthatthe privatesector
can produceat lowercost. See, for example,Viningand
Boardman (1992).
'5See,for example,McDavidandClemens(1995) on
the experienceof local governmentsin BritishColum-
bia; Dilger,MoffettandStruyk(1997) on the experience
who review studiesfroma numberof countries.Someof
these studiesare summarizedin McFetridge(1997).

16However, in some cases, the traditionalpublicsec-
torprovidermaybe permittedto bid for contractsagainst
the privatesector providers.For example,UnitedKing-
dom (2003b)reportsthat,for the managementof prisons
in the United Kingdom,the PrisonService has recently
acceptedin-house bids (in competition)to replacepri-
vate sectormanagementat two prisons.These bids were
successful,in partbecausemoreflexible staffingpermit-
ted the in-housebidderto lowerits price.
'7Thereis some evidencethatthe privatesectordoes
in factdeliverprojects.more
quickly,as proponentsclaim.
TwoUK studiesareworthmentioningin this regard.The
first, by the NationalAudit office is discussed further
below (UK 2003a). The second,preparedfor HMTreas-
uryby MottMacDonald(2002) studied"optimismbias"
("the tendencyfor a project'scosts and durationto be
underestimated and/orbenefitsto be overestimated")and
foundless bias in P3 projects.
'18Examplesof the kindsof risksto be allocatedin in-
frastructureprojects,as describedin Poschmann(2003),
include:(i) technicalrisk(e.g., engineeringor designfail-
ures); (ii) constructionrisk (e.g., higher than expected
costs); (iii) operatingrisk (e.g., morecostly or difficult
to operatethanexpected);(iv) revenuerisk (e.g., lower
thananticipatedlevelsof demand);(v) financialrisk(e.g.,
inappropriate debt management);(vi) force majeurerisk
(e.g., acts of war,naturaldisasters);(vii) regulatory/po-
litical risk (e.g., changes in laws that make continued
operationless profitable);(viii) environmental risk(e.g.,
risk of significantenvironmentaldamageand liability);
and(ix) projectdefaultrisk(e.g., failurethroughanycom-
binationof these risks).
19Weare hardlythe first to makethis point,thoughit
is often moreimplicitthanexplicitin materialsproduced
by the P3 industry.Nova Scotia (1997) is quite good on
this point.Inpreparinga financialcase for a P3 it clearly
becomesimportantto puta valueon riskstransferred and
thiscanbe contentious.See, forexample,Pollock,Shaoul
andVickers(2002) who claim thatthe financialcase for
a numberof hospitalP3s in Britainwas basedon suspect
valuationsof risk transfer.
20Ina worldof imperfectcommitment,of course,some
riskscannotbe transferredcompletelyto the privatesec-
tor, even if that would give the privatepartnerstrong
incentivesto effort.Projectdefaultriskmaybe an exam-
ple. Privatepartnerscantypicallywalkawayfromprojects
PUBLICPOLICY- ANALYSEDE POLITIQUES,
CANADIAN
TheEconomicsof Public-Private
Partnerships 151
thathavebecomeunprofitable (thoughif theyhaveposted
a bondof some sort, this too will carrya cost), butat the
end of the day it is the publicpartnerthathas to see the
service provided.Thus the privatepartnercannotcred-
ibly committo providethe service in all circumstances
andthepublicpartnercannotcrediblycommitto not pro-
vide the service underany circumstances.
211tis importantto recognize that there is a "local"
componentto constructionmarkets.It wouldnot be easy
to move crews and equipmentacross vast distancesjust
to keepthembusy.Thus,evenif a government hadenough
businessin total to allow a firmto achieveefficient lev-
els of production,the costs of moving the capacityto
whereit was neededcould well be prohibitive.
22Thereis the possibility,of course,of a government-
owned construction company achieving its scale or
learningeconomiesby takingon additionalbusinessin
the privatesector.(This was the conceptbehindthe Brit-
ish Columbiagovernment'sill-fated attemptto build
high-speedferries for its own Crowncorporation,BC
Ferries,andalso for marketsaroundthe world.)This is a
good way for a governmentto makeenemiesin the pri-
vate sectoras those firmsare likely to find it unfairthat
they competeagainsta firmfor privatesectorwork,but
they arenot allowedto bid on publicprojects.
23SeeHart(1995), Hartand Holmstrom(1987), and
HolmstromandTirole(1989) forexcellentsurveysof this
literature.
24SeeKingand Pitchford(2000). They too deal with
optimal(publicor private)ownershipin a frameworkre-
lated to that of Hart, Schleifer and Vishny. King and
Pitchford'scontribution comesfromthegeneralityof their
model whichenables themto determineoptimalowner-
ship as a functionof (i) the marginalimpactof efforton
asset value, which can be positive or negative,and (ii)
positiveor negativeexternalities.
25Thisrole of the privatecontractor- bringingex-
pertise - is especially critical in less developed and
developingcountrieswherethe necessaryexpertisemay
just not be easily acquiredwithin government(or any-
wherewithinthe country).FourieandBurgersuggestthat
in SouthAfrica,"alackof management capacityin govern-
mentis a primeargument fora PPPinitiative"(2000,715).
261nthe privatesector,firmsthatareunderperforming
can be sold to otherownerswho can profitby fixing the
VOL.XXX,NO. 2 2004
152 Jean-Etiennede Bettigniesand ThomasW Ross
problems.Thisis notpossiblewithpublicsectorprovision.
27See,e.g., United Kingdom,NationalAudit Office
(2003a, 1) andMcFetridge(1997, 43-44). This is one of
thereasonsthecontracthas to be for a largefractionof the
assets.McFetridge
usefullife of theconstructed claimsthat
the combined costs of construction,mainte-
minimizing
nance,andoperationis thebenefitmostrecognizedby the
privatizedprisonsin the UnitedStates.
28Thetheoreticalliteraturehas studiedthe "bundling"
of constructionandserviceprovisionas a definingchar-
acteristicof P3s. See our discussionof Hart(2003) and
Bentz, GroutandHalonen(2002) below.
29Thisincentiveeffect is magnifiedif the samefirmis
providingthe financingfor the project.We returnto this
below.
30Mostof the operationcontractsof substantialfacili-
ties are very long term - 20 years and longer is not
unusual.In partthe reasonis thatthis allowsthe govern-
menta longerperiodto payoff thecapitalexpensethrough
lease payments.However,this point also illustratesthe
advantageof makingthe contractlengthroughlyequiva-
lent to the useful life of the facility.
31Relatedis theconcernthatif the privatepartnerever
founditself in financialdistress,it wouldbe temptedto
cheateven on contractedlevels of quality.As the failure
of the privatecontractorcan be chaotic for customers,
the publicpartnerwill be reluctantto enforcecontractual
obligationsthatput the contractorat riskof failure.This
is like a situationin which both sides beganwith "hos-
tages" to enforce mutualcontractcompliance,but the
hostageheld by the publicsector(profitsfromcontinued
operationunderthe contract)lost its value. The use of
hostages to support exchange was described by
Williamson(1983).
32Ithas been suggestedthat some aspects of quality
may be very difficultto makeenforceablepartsof a con-
tract and, if they are very important,this may mitigate
againstusing the P3 form. See, e.g., Hart,Schleiferand
Vishny(1997).
33Theparametersarechosensuchthatin the first-best
the unproductiveinvestmentshouldbe set to zero.
34Seealso KingandPitchford(2000), andBennettand
Iossa(2003) for moregeneralanalysesof bundlingof two
CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VOL. XXX, NO. 2 2004
activities, which share similaritieswith Hart,Schleifer
andVishny(1997) andHart(2003).
35TheWorldBankhas an activeP3 programsupport-
ing partnershipsfor infrastructure
projects.
36lndependent governmentauditorsmaynot be fooled
and can representa check on this behaviour.
371nthe simplest case, there should be no difference
in the "true"cost of capitalbetweenthe publicand pri-
vate sector.This point was madeby Grout(1997) with a
veryelegantexample.However,if thereis a differencein
the cost of liquidatinga failed projectdependingon who
providedthe financing,this could createsome difference
in borrowingcosts betweenpublicandprivateborrowers.
3Ilndeed, in less-developed countries, large private
corporationsmay be more reliable debtorsthan the na-
tions in which they are working.
39Thiswas also very clearly noted by Daniels and
Trebilcock(1996, 409).
40A relatedissue, which we do not take up here, in-
volves the question of how the privatepartnershould
financea P3; thatis, whatproportionsof debt andequity
are optimalfrom the public's perspective.The answeris
not as simple as it might be for privatefirmsin unregu-
latedmarkets.Forexample,if a P3 providinganessential
publicservicerunsinto seriousfinancialtrouble,thegov-
ernmentwill be underconsiderablepressureto bail out
the privatepartnerso that the service flow is not inter-
rupted.A cushionprovidedby substantialprivateequity
reducesthe probabilitythat risks will be shiftedback to
the governmentin this way.
41Inits surveyof P3s in the UnitedKingdom(2003a,
3, Table 1), the National Audit office reportedthat 22
percentof surveyed PFI (P3) constructionprojectsex-
ceededprojectedcosts (some with good reason)while in
an earlierstudy it had foundthat 73 percentof govern-
ment constructionprojectsmanagedin traditionalways
hadgone overbudget.Further,in theirsamples,about76
percentof PFIprojectswere deliveredon time (or early)
comparedto about 30 percentfor traditionalmethods.
Withouta clearideaof howtheestimatesof cost andtime-
to-completionarepreparedwe cannotconcludefromthis
thatPFI projectswere really less costly or morequickly
delivered,so this questionneeds furtherwork.

TheEconomicsof Public-Private
42Onelesson not listed below,becauseit has moreto
do with political thaneconomicconsiderations,may be
worthnoting nonetheless.To the extent that voterswill
acceptuser-paysystemssuch as tolls morereadilyif the
toll revenueis going to a privateconcessionairerather
thantheirgovernment,publicofficialscommittedto user-
pay to finance the project may determine that a P3
structurewill meet less publicresistance.
430f course, if the privateprovidercan producethe
service moreefficiently,thereis still a social gain to al-
locatingit the task, even if its priceis high. In this case,
while taxpayersmay not save any money,the economy
still conservesresources.
44The need for the continuingapplication of scarce Crocker, K. and S. Masten. 1996. "Regulationand Ad-
skills likely has muchto do with the popularityof P3s in
developingcountries.
45Forexample,the Frenchwatergiants like Vivendi,
whichprovideservicesto manymunicipalities in Franceand
elsewhere,can spreadsome of the fixed costs of design,
R&D,andmaintenance acrossa largenumberof projects.
review of the Britishexperiencewith
46Spackman's
P3s leads him to believe that "the main driversappear
still to be ideology and accounting"(2002, 283). That
said, he sees potentialbenefitsfrom P3s and believes a
numberof importantlessons have been learnedin Brit-
ain (e.g., 297-98).
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