Ownership and Cost-Sharing Contracts

We discuss the relative merits of public and private ownership in an incomplete contract framework developed by Hart, Shleifer and Vishney (HSV). We add two new elements to their model. First, the government may offer cost-sharing contracts when procuring the good. Second, the owner of a private firm may divert resources that increase their own profit/utility but increase total costs. The cost sharing contract allows the government to reduce the private firm's incentives to dump quality in order to save on costs. However, this also leads to resource diversion, which increases total costs. We derive the preferred mode of ownership when the government optimally chooses the power of the cost sharing scheme. We find that the presence of quality-reducing cost reductions only favours government ownership if the scope for resource diversion is substantial. A discussion of when resource diversion is likely to be important is also provided.