Arm’s Length Outsourcing

We analyze the economic consequences of strategic delegation of the right to decide between public or private provision of governmen-tal service and/or the responsibility of negotiating with the chosen service provider after a contract has been signed. Our model is broad enough to encompass both bureaucratic delegation from a government to a privatization agency and electoral delegation from voters to a gov-ernment. We show that it is a powerful instrument for the principal to achieve better allocation of resources and to obtain a lower price from private service providers. When inhouse production is preferred delegation can indirectly offset weak incentives in the public sector. When outsourcing is preferred, optimal delegation is to an agent, who is a the brink of choosing inhouse provision. Such an agent is a strong negotiatior with the firm and offsets market power