Oliver Hart, a Nobel Price winning economist, made the following case against privately founded prisons in an interview from 2017: “There are some things that are difficult to specify [in a contract between a government and a private prison]. One is the quality of the guards. A private company may have incentives to hire cheaper, less trained guards and yet still be within the contract.

What is this type of contractual problem called? Why does it occur?

Hello everyone,

I'm struggling with the question above. It is from and old exam in my lecture 'Organization and Management' (consisting mostly of contract theory).

I think the question is either aiming for:

  • 'Incompleteness of contracts' since the "quality of guards is hard to specify". Probably because the quality is observable but not verifiable (or specifying the quality would be too costly) OR
  • 'Adverse Selection' since the government does not know what kind of cost function a private company would have (for the quality of the guards) prior to signing the contract.

Now that I wrote that I feel like it must be the former just because it makes sense to me.

What do you think? May the contractual problem at hand also be something entirely different?

Thank you in advance, Chris


This looks like a case of incomplete contracts, or what is sometimes known as non-contractibility.

In the principal/agent paradigm, adverse selection arises when an informed agent transacts with an uninformed principal and, in particular, the principal cannot distinguish between desirable and undesirable agent trading partners.

I don't think your example is a good fit for adverse selection: here the principal would be the government and the agent would be the prison company. But the quality uncertainty concerns the guards rather than the agent itself, and the government is not directly interacting with the guards here.

From the world of information asymmetries, this looks more like a situation of moral hazard where the agent is not incentivised to act in the prinipal's interests. Moral hazard is only really a problem when you Cann't write a contract stipulating thet the agent should behave in the principal's interests. This could be for various reasons

  • the agent's action can't be directly observed;
  • while the angel't action cab be observed, its badness can't be objectively verified (i.e., it can't be conclusively proven in court that the action was bad, so a court could never enforce the contract);
  • the number of contingencies is so large that it is impossible to write a contract specifying all of them
  • there is no relevant authority to enforce the contract (e.g., a drug dealer and his supplier can't write a meaningful contract because they can't exactly expect a court to enforce it)

In the above-mentioned quote, Oliver Hart is talking about a problem caused by incomplete contracts. Specifically, he is referring to the following paper:

Hart, O., Shleifer, A. and Vishny, R.W. (1997). The proper scope of government: Theory and an application to prisons. Quarterly Journal of Economics, 112, 1127-1161.

The incomplete contracting approach to the theory of the firm (sometimes called the property rights approach or the GHM model) was developed in the following two papers:

Originally, the incomplete contracting approach dealt with the question when integrating private firms is optimal. Hart et al. (1997) have applied the incomplete contracting approach in order to study the pros and cons of privatization. In their model, the government negotiates with a manager over the provision of a public good, the quality of which cannot be fully described in a formal contract. The manager can make non-contractible investments to come up with innovations. Ownership determines who has the right to implement innovations. Under private ownership, the manager would always implement cost-reducing innovations, even when they significantly reduce quality. Therefore, under private ownership there is over-investment in cost reductions. Yet, public ownership leads to under-investments. Whether private ownership or public ownership is optimal depends on the details of the problem.

The model by Hart et al. (1997) is the leading application of the incomplete contracts paradigm to the theory of privatization. Their work has been extended in various directions. For more recent contributions, see for example:


What is this type of contractual problem called? Why does it occur?

That sounds like a inconsequential, "trivia" question which has neither relation to the doctrine of contract law nor relevance to how contracts work in the real world. Other than considerations of utility and budget constraints, it is unclear to what extent the contract theory covered pursuant to that lecture refers (or should refer) to the legal doctrine of contract law.

The difficulty of specifying the quality of guards has nothing to do with the fact that the contract is entered by a public entity and a private one. A government needs to reasonably define the specifications of any service, regardless of whether or not that service will be outsourced.

The government does not need to know a counterparty's cost function. Legally speaking, what matters is whether both parties knowingly and willfully accept the terms of their contract. Economically speaking, the government only needs to compare (for a given list of minimal specs) the numeric output of its own cost function versus the price tag proposed by the private entity. Alternatively, for a government would have to assess whether for a given budget the provided services will satisfy the government's needs.

As an analogy, when you buy a product, the only aspects that should matter to you are the utility you would obtain from the product and your budget constraint, not how much it costs the manufacturer to produce that good. It would be bizarre for a party to make its requirements dependent primarily on the counterparty's cost function.

May the contractual problem at hand also be something entirely different?

Yes, at least from the legal standpoint. For instance, the lack of specificity in a contract permits the party who is not the draftsman of the contract to invoke the doctrine of contra proferentem (that doctrine allows the private entity "to hire cheaper, less trained guards and yet still be within the contract").


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