Public management researchers have successfully leveraged theory to advance the understanding of contracts and the different governance structures that underpin contract relationships. Yet there is still much to learn about the implications for different governance structures. Applying insights from property rights, the purpose of this paper is to examine the substance of initial government contracts and their subsequent amendments in order to determine whether allocation of decision rights leads to better or worse contract amendments.
The authors evaluate the text of initial contracts and their subsequent amendments in 258 government–business relationships and focus on the implications of assigning key decision rights to the party with most relevant knowledge expertise.
Two primary findings are presented. First, initial contracts where knowledge expertise and the associated decision rights are co-located (i.e. integrated) are likely to be associated with ex post adjustments that benefit both parties to the contract. Second, the authors find that this initial finding is likely a result of government integration as opposed to supplier integration.
Given that we know most professional service contracts require some form of contract amendment over time, this research helps us understand why some amendments will reinforce the collaborative (Pareto enhancing) nature of the relationship, while others may be more one sided (rent seeking). Unlike other theoretical approaches (e.g. transaction cost theory), property rights theory provides guidance for such decision making.
Malatesta, D. and Smith, C. (2019), "Contract amendments: for better or for worse?", International Journal of Public Sector Management, Vol. 32 No. 6, pp. 635-652. https://doi.org/10.1108/IJPSM-06-2018-0141Download as .RIS
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Copyright © 2019, Emerald Publishing Limited
Empirical evidence suggests many contracts are renegotiated and amended before their specified end-date. Given that amendments can be costly, it is important to understand why renegotiations occur. Moreover, if amendments are unavoidable, as some theories claim, we need to understand how the terms of the initial agreement affect subsequent renegotiations and amendments. Research on contract renegotiations and amendments has been the subject of much attention in the economic literature but has not received much attention in public management. This is unfortunate given that governments rely heavily on outsourcing, including for the delivery of many core services. In addition, despite ample literature describing inherent differences between government and business, very few contract studies consider that outcomes may differ by sector. We need to understand more about the factors that lead to different types of amendments. As Oxley and Silverman (2008) note, we need studies that “explicitly connect renegotiation to actual or perceived performance” (p. 231).
We investigate property rights theory (PRT) in the context of government contracts for professional services. We examine the text of initial contracts and their subsequent amendments, focusing on how the initial allocation of decision rights affect ex post adjustments to the contract relationship. A key proposition of PRT concerns the allocation of decision rights and the benefits derived from co-locating ownership of key assets, including knowledge expertise, with the rights over the use of those assets. The co-location of ownership and assets is referred to as “integration.” Simply put, an integrated governance regime provides the incentive to appreciate the assets’ value. Consequently, subsequent amendments should provide for adjustments that extend benefits. The theoretical contribution is an evaluation of PRT’s main propositions as they relate to government contracts with providers of professional services. Empirically, we add to the limited body of evidence on the implications of governance choice and on differences in sector performance.
The paper proceeds as follows. The second section provides the theoretical framework. This section clarifies PRT’s main constructs, including assets, ownership, decision rights and integration, and connects PRT to the context of the present study – government professional service contracts with knowledge expertise being the key asset for production. The third section describes the research application and results. We find general support for a key claim in PRT: the allocation of decision rights in the initial contract has implications for the substance of amendments that follow. The fourth section is a discussion of results and implications.
Property rights: theoretical overview
The term “property right” concerns assets used in the production of goods (Barzel, 1997, p. 3). Assets can be either tangible, as in the case of a physical building, or intangible, as in the case of knowledge. Since professional service contracts engage professionals, the key asset used in the production process is knowledge. For example, a law office that provides the government with legal services possesses important knowledge assets, i.e. the expertise of attorneys employed by the firm who carry out the work. Modern PRT equates ownership with control of rights in the deployment of specialized assets. Thus, in the language of PRT, knowledge assets (legal know-how) are considered “owned” by the party directing the work effort under contract.
Rights of control, also called decision rights, are particularly relevant in an incomplete contracting environment. The backdrop for outsourcing professional services includes laws and regulations, agency policies, as well as a technology and labor market, all of which are subject to change. This inevitable uncertainty means that contracts are incomplete as parties cannot specify a course of action for every conceivable contingency. From this viewpoint, contract amendments are anticipated and perhaps unavoidable.
The term “integration” in the literature refers to the locus of decision rights in relation to key assets (e.g. Schmitz, 2006). Specifically, “integration” concentrates ownership (knowledge) and control (decision over the use of knowledge assets), while “non-integration” separates ownership and control. For example, a social service agency may outsource the administration of one of its social programs, a governance structure considered “integrated” if the government retains decision authority over the work done by the supplier. In such a case the social service agency is presumed to have the requisite knowledge to implement the program because it is closely associated with the agency’s mission; it is a core service. For another example, the same social service agency may outsource legal services. In this case, expertise resides with the supplier, not the agency. In fact, the agency probably outsources to obtain expertise it does not have. If the law firm has the authority to direct the legal work to be done, either explicitly or implicitly, this is also a form of integration. Thus, integration refers to the co-location of knowledge assets and related decision rights, whether both reside with the buyer (government) or with the supplier (contractor). In contrast, non-integration refers to the separation of expertise and related decision rights, for example, if government is the expert (as in the case of a core service) but the supplier directs the work effort or, if the supplier is the expert but the government directs the work effort.
Next we discuss the implications of integration for the substance of contract amendments.
Integration: a governance regime that co-locates knowledge and decision rights
An integrated governance regime that includes asset ownership and decision rights incentivizes parties to invest and grow the assets’ value. Moreover, when expert knowledge is the key asset, the benefits of integration go beyond incentives. In this setting experts are well-positioned to make the best use of new information and thus to improve collaborative processes. The integrated party has the prerequisite knowledge to more fully engage in task management and to recognize adjustments needed to facilitate contract performance and maximize the parties’ surplus. The non-integrated party is also incentivized to perform. If not motivated by reputational concerns or by the potential for additional work, because a lack of effort is likely to be detected by the integrated party who possesses the expertise as well as the decision rights to exact penalties. Close (informed) monitoring can encourage investment in (unobservable) effort, otherwise considered non-contractible.
Aghion and Tirole’s (1997) distinction between formal and real authority is useful for further understanding the advantages of integration when knowledge is the key asset. Specifically, contract language specifying decision rights may confer formal authority but not necessarily real authority. Real authority requires a degree of knowledge. “A principal who has [only] formal authority over a subordinate’s decision is likely to refrain from doing so if the subordinate is much better informed” (p. 2). An uninformed decision is risky. An uninformed principal “is inclined to rubber stamp a subordinate’s proposal for fear of choosing a worse alternative” (p. 3). Even if the principal wants to obtain information and become better equipped to make a decision, he/she is likely to face a challenge. That is, a principal with only formal authority can be overloaded with many activities and not able to acquire relevant information (pp. 2-3). Following this logic, integration-the co-location of expertise (ownership of knowledge assets) and authority (control over decision rights) with either government or the supplier will increase the likelihood that decisions are informed and increase the informed party’s participation in the contractual relationship. The integrated party is more likely to be engaged in day-to-day task management because it has real authority (prerequisite knowledge) to facilitate the performance of the contract.
Mayer and Argyres (2004) argue that enhanced participation in the contract work leads to local and incremental learning. As a result, parties learn what contract provisions should be adjusted to meet performance goals. In addition, the parties gain foresight and thus adjust clauses to incorporate possible contingencies. Increased interaction can also lead to an increase in responsibilities for both sides. Williamson (1985, p. 34) refers to this as “hazard equilibration” wherein the parties agree to added reports or new milestones as a means of averting a contract breakdown. Thus, contract adjustments that derive from enlightened interaction are likely to enhance the working relationship and benefit both sides.
The cost associated with the transfer of expert knowledge provides another rationale for the co-location of expertise and decision rights. Expert knowledge has the characteristic of what Imai and Itami (1984) calls ‘invisible resource” and what Von Hipple (1994) refers to as “sticky information.” Because knowledge assets are not easily codified and not easily transferred they are also not contractible. Consequently, the co-location of expertise with decision authority is efficient. According to Jensen and Meckling (1992), organizational efficiency requires that those ultimately responsible for decision outcomes also have the knowledge valuable to those decisions. The same logic can be found in early writings of scholars. Hayek (1935) argues that centralization of decision making is only efficient if the central planner has the knowledge that is specific in time and place. Also, March and Simon (1958) posit that delegated decision making makes sense when a supervisor has limited information-processing capabilities. Thus, from the perspective of PRT, the relationship between knowledge assets and decision rights is as follows: the more intangible knowledge assets one person has relative to another person the more important are his assets for the generation of income, and the more decision rights should be assigned to that person.
When the initial contract provides for an integrated governance structure, partners develop a preference for mutually beneficial contract adjustments rather than one-sided opportunistic adjustments (Kale et al., 2000). Amendments that are mutually beneficial are considered Pareto improving (Guasch et al., 2007, 2008). Pareto-improving amendments are the result of good faith attempts to deal with unanticipated conditions and keep ex post costs to a minimum (Masten, 1988). Pareto-improving amendments occur when new information is revealed in a productive collaborative relationship (Roberts and Sufi, 2009).
Applying PRT, the separation of knowledge assets and decision rights (non-integration) is not preferred. The same logic applies to any form of integration, that is when government has the requisite expertise but defers to the supplier for decisions regarding the use of knowledge assets, or when the supplier has the expertise but defers to the government for decisions regarding the use of knowledge assets. Knowledge costs and coordination costs are higher under non-integration compared to integration. Under non-integration, the threat of underinvestment (in effort) is also higher compared to cases involving integration. The cost of monitoring is increased when effort is unobservable or difficult to evaluate. Thus, compared to non-integration, integration is more likely to be associated with Pareto-improving amendments.
To consider all possibilities, there are a few reasons an integrated party will not be motivated to invest. The integrated party may lack resources to commit effort, or if services are highly complex, a lack of effort may not be easy to detect, even by experts. Such a result is possible whether government or the supplier possesses the expertise and the decision rights. In the case of an integrated supplier, there is a chance that it may want to protect future rents through the shirking of responsibilities (Laffont and Tirole 1993, p. 375).
Consequently, on balance we expect the following when either party has both the expertise and the decision authority over the work produced:
A positive relationship exists between (all) integrated governance regimes and Pareto-improving contract amendments.
To this point we have mainly used PRT to guide our predictions, hence H1 is generalized to all integrated governance regimes, with no distinctions for organization type. Importantly, from the view of PRT, the concentration of ownership (knowledge assets) and control (associated decision rights) provides several advantages regardless of the party’s identity. Accordingly, all integrated governance regimes are expected to lead to Pareto-improving amendments.
With regard to rent-shifting amendment, similar generalized predictions are supported in both PRT and in transaction cost economics. For example, Williamson and other scholars emphasize that opportunism is widespread, making no distinction between public and private sector motives and outcomes. Gibbons (2010) makes a similar point: if [any] party is given the chance, incomplete contracts will lead to inefficient haggling (2010, p. 273, footnote 8; emphasis added). Thus, in general, theory posits that haggling results when authority is not centralized, whether the party involved is government or business (see Myerson and Satterthwaite, 1983).
However, public management literature, mainly that associated with public sector motivation (PSM), offers a competing perspective with respect to rent-shifting amendments. From the viewpoint of PSM, there are important difference in sector purposes and outcomes. A main idea of PSM is that persons motivated by public service place a high value on work that helps others and benefits society (Rainey, 2014, pp. 314-317). For example, Perry and Wise (1990) model public service motivation (PSM) with three analytically distinct categories: rational, norm-based and affective. Rational motives relate to the utility one derives from helping others (p. 368). Norm-based motives are value-based, for example, one’s sense of patriotism; whereas affective motives serve “an emotional response to humankind, which brings with it a willingness to sacrifice for others” (p. 369). These ideas find support in research applications (e.g. Khojasteh, 1993). And, higher levels of PSM have been linked to higher performance. For example, Alonso and Lewis (2001) find that employees with higher levels of PSM received higher ratings from their supervisors. Likewise, Naff and Crum (1999) find those who expressed higher levels of PSM had higher levels of job satisfaction and higher performance ratings from their supervisors.
Viewed as a whole, the literature supports, if not presumes, opportunistic motives apply to the private sector (supplier), that is for-profit organizations. Thus, supplier organizations may prefer one-sided amendments as opposed to the mutually beneficial amendments (Pareto-improving). Amendments that are not mutually beneficial and that benefit only one side are considered rent-shifting (Guasch et al., 2007, 2008). Consequently, when the supplier, a for-profit organization has both the expertise and the decision authority, we expect the following hypotheses with regard to Pareto-improving and rent-shifting amendments:
A negative relationship exists between supplier-integration and Pareto-improving contract amendments.
A positive relationship exists between supplier-integration and rent-shifting contract amendments.
Turning to government integration, based on the discussion grounded in PSM, there is reason to believe that when government knowledge and decision rights are collocated with the government, Pareto-improving amendments will ensue. However, we argue the logic and evidence on public sector motives is at least enough to overcome the presumption of opportunism for government but perhaps not enough to predict a negative relationship between government and rent-shifting amendments. Consequently:
A positive relationship exists between government integration and Pareto-improving contract amendments.
No significant relationship exists between government-integration and rent-shifting contract amendments.
The sample frame includes all professional service contracts executed between 2004 and 2013 and any subsequent amendments from two Indiana State agencies: Family Social Services Administration (FSSA) and Department of Child Services (DCS). Contract amendments are dated as late as December 2017. All contract documents and exhibits were pulled from the state’s website. Following Roberts and Sufi (2009) we focused on the first contact amendment subsequent to the signing of the contract, which is most likely to reflect the strengths and/or weaknesses associated with the original agreement.
Preliminarily, about 66 percent of professional service contracts on the state website contracts are marked as amendments compared to those marked initial contracts or renewals. The sample selection strategy reflects several objectives. The overall sample had to be large enough for statistical testing. No single state agency satisfied this condition. Consequently, we downloaded all contracts from two agencies that provide similar services, FSSA and DCS. Contracts by agencies with similar purposes and missions are likely to be similar in structure and purpose (see also Arruñada et al., 2001). To evaluate PRT’s theoretical relevance to government contracts, the sample of contracts required a sufficient variation in outcomes (Pareto-improving and rent-shifting) and the full range of variation in governance regimes (integration and non-integration) (Seawright and Gerring, 2008). Finally, the sample selected should reflect similar proportions observable in the sample frame. Random samples of the entire sample frame indicate the final selection should include about 45 percent Pareto-improving amendments and about 40 percent integration.
Our final sample includes 258 original contract documents and their first amendment. The combined volume of contracts for these two agencies provides a sufficient sample size for statistical techniques. In addition, the contracts in our sample meet the criteria of “structured diversity” (see also Anderson and Dekker, 2005), which is to say they are characterized by both a degree of standardization and a degree of heterogeneity. The contracts are standardized in that many provisions are boilerplate and required by state guidelines.
We took several steps to objectively and reliably code relevant contract language. We carefully reviewed the agreements along with other state documents to identify key features and variations in the agreements. The Indiana Department of Administration’s manual of contract guidelines was a key source for understanding the contract language. We also consulted with agency personnel to when necessary to clarify the meaning of specific provisions. After several iterations we developed a coding form to capture key contract features. We followed guidelines in Neuendorf (2002) for coding practices, operationalizing measures, reconciling coding inconsistencies and establishing inter-coder reliability. Two different individuals coded key features of the contracts and information from the agencies’ mission statements; each coded all content at least twice. To reduce coding errors, the coding task was confined to manifest content, recording values of either 0 (absence) or 1 (presence) for most provisions.
Using the coding guidelines described above, we coded Pareto-improving amendments and rent-shifting amendments based on literature describing each type of amendment and a detailed textual analysis of the contract documents. Both dependent variables are binary. A Pareto-improving amendment is one that improves the position of both parties. Pareto-improving amendments clarify terms or extend the contract under the same terms and conditions (see Segal, 1999). This description is also consistent with Masten (1988) who refers to similar ex post adjustments as mechanisms for hazard equilibration. In contrast, a rent-shifting amendment improves the position of either the government or the supplier but not both (Gausch et al., 2008). Table I includes coding guidelines, literature supporting each construct and example language from contracts associated with the dependent variables.
Integration structure is our main independent variable. The construct has two parts: the locus of knowledge assets and ownership/decision rights. Consistent with the definitions of ownership and decision rights in the property rights literature, the location of knowledge assets and decision rights are combined to determine whether the ownership structure is integrated (Grossman and Hart, 1986; Hart and Moore, 1990). With respect to knowledge assets, we compared the mission statements of the government agencies (FSSA and DCS) to the work described in the contract. Work under contract is coded as core to the agency if it directly relates to the agencies’ mission, in which case the locus of knowledge assets resides with government and the value=1. If the work is not directly related to government we consider it ancillary, in which case knowledge assets reside with the supplier and the value=0. The measure is similar to intangible knowledge assets constructed by Gurcaylilar-Yenidogan and Windsperger (2013) and Windsperger (2009).
The second part of the construct, decision (control) rights is also based in contract language. Control rights either rest with government or the supplier. Provisions that name key employees are especially notable in our contract sample. These provisions require the supplier to commit specific employees to engage in the work effort. In some contracts the provision includes language that allows for termination if the key employee is no longer available for work, and/or allows the government, if it so desires, to hire the employee directly. In our view, the key employee provision is an asset specific investment by the supplier because costs cannot be fully recovered if the contract is terminated or if the key employee leaves to work directly for government or to work as an independent contractor on her own. Moreover, key employee provisions provide government with a residual claim over knowledge assets.
Table II includes coding guidelines, literature supporting each construct and example language from contracts associated with the main independent variables. As noted in the table, there are two pathways to integration. First, integration occurs when the government possesses the decision rights (coded 1) and is the location of knowledge assets (i.e. a core service) (coded 1). Second, integration occurs when the supplier possesses the decision rights (coded 0) and the knowledge assets reside with the supplier and thus the service is ancillary to the government’s mission (coded 0).
Table III provides a breakdown of the sample by integration/non-integration. The modal category in our sample (cell B in the table) is a form of non-integration where the government possesses the decision rights, but the knowledge assets reside with the supplier (i.e. an ancillary service). Of the contracts in our sample, approximately 41 percent are coded as integrated (cells A and D in the table). In addition, Table IV provides information about the number of contracts amended and the subsequent type of amendment.
To control for other effects and to test for alternative explanations we included various other measures in our models. The method of source selection (RFP, bidding, negotiation or special procurement) indicates whether there was competition in the award to initial contract. Investment in work effort can be a function of availability of other suppliers (Klein et al., 1978, p. 313).
Bargaining power may also be important to decision allocation (Elfenbein and Lerner, 2003), ex ante and ex post. As is the case with many governments, Indiana contracts provide the state with a powerful bargaining position; all contracts give Indiana the right to terminate for the contract convenience. The termination for convenience clause also incentivizes supplier performance. Also, state regulations permit organized interests to lobby executive agencies. As argued by Libecap (1989) political agreements define the actors who have a stake in subsequent changes in property rights. Lobbyist information comes from two sources, the state’s database of registered lobbyists and the vendor code on the contract’s Executive Document Summary (EDS). If the organization under contract was registered to lobby either executive agency in any of the five years leading up to the contract signing the value is coded as 1, 0 otherwise.
The importance of the service under contract is associated with the need to avoid decision errors and thus may affect allocation decisions (Jensen and Meckling, 1992). The dollar amount is a proxy for contract importance; the variable is in logarithm form to correct for its skewness. In addition, contracts with a higher dollar value may be associated with more complex services; effort and performance are not easily detectable when services are complex.
Given that government agencies often contract for ancillary services, it is likely that agencies with fewer contracting opportunities might make poor decisions when writing the contract – regardless of integration. To account for this possibility, we control for the number of contracts executed during the year prior to the relevant contract year is a proxy for contract experience.
Finally, following Gulati (1995) we coded for any previous working relationship (contract) (previous relationship) between the government and the supplier. To determine if the government and supplier had a previous contract relationship we matched the vendor number on the contract with vendor numbers in the online IDOA contract repository. Table V provides the number of observations for the various strata and the descriptive statistics for all variables used in the study.
Econometric approach and findings
Table V shows nearly half of the contracts in our sample are Pareto-improving amendments (43 percent); whereas only 22 percent of the contracts exhibit rent-shifting amendments. From a governance perspective, this suggests that when the need for contract adjustment arises, the parties are more likely to agree on changes that are beneficial to both parties than they are to agree to changes that benefit only one party.
Table VI presents the results of the probit regression analysis. The main independent variables across the regressions constitute variations in integration type. In addition to our general integration variable (regression 1), we parse integration by form – government integration and supplier integration – to test whether there are differential effects based on whether the colocation of knowledge assets and decision rights are situated with the government or the supplier (regressions 2 and 3). In the subsequent regressions (4–6), we examine different variations of the sample (amended only and integrated only), as well as provide a regression focusing only on government decision rights.
Regression 1 presents the most direct test of H1. The positive, statistically significant coefficient provides empirical support for the hypothesis that integration (government or supplier) will lead to more Pareto improving amendments. Indeed, integration increases the likelihood of observing a Pareto improving amendment by approximately 8 percent. Moreover, we find that a previous relationship between government and the supplier will increase the likelihood of Pareto-improving amendments by about 0.11 (p<0.01) compared to contracts involving parties that have not previously contracted with each other. We also find that when suppliers (or their employees) are registered with the state to lobby, the likelihood of a Pareto-improving amendment decreases by 0.28 (p<0.01).
While regression 1 suggests that integration will lead to more Pareto-improving amendments, there are theoretical rationales (see discussion on PSM) as well as empirical reasons (see Table IV) to suggest that there might be a significant difference between government and supplier integration. Regressions 2 shows that there is positive, statistically significant relationship between government integration and Pareto-improving amendments (support for H3a). However, the relationship between supplier integration and Pareto-improving amendments is not statistically significant (lack of support for H2a). In regression 3, we find that government integration has no significant impact on rent-shifting amendments, which is consistent with H3b. Regression 3 also shows that supplier integration increases the likelihood of rent-shifting amendments, which provides support for H2a. These results suggest that the positive relationship between our general integration variable and Pareto amendments is driven primarily by government integration.
Given that we are analyzing a broad array of contract governance/amendment combinations, it is important to consider alternative samples for estimation. Regression 4 includes only amended contracts. All non-amended contracts (roughly one third of the full sample) are dropped from the model. The results demonstrate a strong negative relationship between supplier integration and Pareto amendments; however, the previous positive relationship between government integration and Pareto amendments is now insignificant. Referring back to Tables III and IV, the distribution of the contracts by type suggests that decision rights may be a more important determinant of improved contracting than knowledge assets. To test this (regression 5), we created a variable where contracts with decision authority situated with the government are coded 1; all other contracts are coded 0. Focusing on amended contracts only, we find that the relationship between Pareto amendments and government decisions rights is positive and statistically significant. In fact, the relationship is relatively strong – government decision rights increase the probability of a Pareto improving amendment by roughly 17 percent.
Lastly, to further examine the differential effects of government vs supplier integration, we provide a regression that only considers amended contracts and integrated contracts. In other words, regression 6 is the most direct test between the different forms of integration, albeit at a loss in sample size (n=83). Here we find that government integration has a positive and statistically significant effect on the likelihood of Pareto improving amendments.
On the whole, these findings suggest that while integration does impact the substance of contract amendments as PRT suggests, the type of integration appears to be more important in government–supplier agreements for professional services. Specifically, government integration tends to lead to mutually beneficial adjustments when compared to other governance arrangements, such as non-integration and supplier integration. In the next section we discuss the implications of these findings.
Discussion and conclusion
This research investigates PRT in the context of government outsourcing relationships, specifically government contracts for professional services. Government contracts for professional services fit the standard incomplete contract environment associated with PRT. Services are complex and difficult to specify. Oftentimes government can only generally describe what it needs. The dynamics of politics, regulation and policy add further complications for specifying and verifying tasks and quality. Our research approach uses a unique set of government contracts to perform a textual analysis of the parties’ initial agreement and subsequent renegotiated amendment.
From the perspective of PRT, contracting parties enter into an agreement based on non-verifiable information – particularly the level of effort each party will dedicate after the initial deal is struck. Against this backdrop, task complexity and uncertainties about how the other party will behave imply a work environment conducive to opportunistic behavior. The parties solve this problem by allocating decision rights to motivate investment in effort. As the relationship and the work evolves, the parties learn more about each other’s level of investment and the state of nature, which leads them to make contract adjustments. Pareto-improving amendments arise when parties’ investments in effort lead to an effective collaboration that reveals ways to preserve and enhance the contract relationship going forward. More specifically, a relationship surplus will arise when assets and ownership are integrated. Thus, an effective allocation of rights in the initial agreement should enhance the contract relationship and lead to mutually beneficial contract amendments whether the parties involved are government or business organizations.
To summarize our findings, renegotiation improves the contract relationship to the benefit of both parties, so long as the expertise and associated decision rights reside with government in the first instance; when expertise and associated decision rights reside with the supplier (a private sector partner) we have no evidence that renegotiation is mutually beneficial. The findings suggest that while PRT logic is useful for evaluating government contract relationships, it assumes a similarity between partners’ type regardless of sector. Yet this research implies that these differences may be meaningful in that the results are consistent with literature emphasizing the distinctions between the public and private organizations, which argues among other points that government organizations operate in accordance with different values and motives when compared to their private sector counterparts.
Comparing our results with previous research is less than straightforward. Only a small number of papers employ property rights logic in the evaluation of government contracts, most of which treat ownership as an either-or choice between direct service by government or privatization (e.g. Grossman and Hart, 1986; Laffont and Tirole, 1993). However, as our approach indicates, government outsourcing relationships typically involve degrees of ownership and control. Desrieux (2009) refines PRT with formal models that include varied allocations of property rights. Similar to Desrieux, this research conceives of ownership in the sense of control over expertise (knowledge assets), that is, the parties’ respective rights to decide who will perform important tasks and how the work effort will be carried out. Yet, the empirical results here do not square with Desrieux. Specifically, Desrieux’s model shows there is a degree of private involvement that makes it possible to outperform public services. The differences in the results presented here may be explained by the political environment and the level of competition. We include a variable for lobbying to at least partially control for the political environment; we also include a control for supplier competition, which may curb opportunistic behaviors. In addition, Indiana state policy requires a standard termination for convenience clause in every professional service contract and mandates that no change can be made to the scope of services without prior consent of the government. Collectively, it is very possible that these standard clauses put the parties on a level playing field when it comes to bargaining initially and at the time of renegotiation.
This research is subject to several limitations. Our sample selection strategy is consistent with evaluating the main propositions of PRT and the effects of decision allocations on the substance of amendments. Although the resulting sample includes proportions of amendment type and decision allocations that are consistent with overall numbers in the larger database of state contracts, we do not claim the sample is representative of all contract amendments or all government contracts. In addition, our focus is on the substance of amendments and not on the reasons amendments occur in the first place. Nevertheless, the sample, along with our results, is informative for PRT theory (Seawright and Gerring, 2008).
We also acknowledge that our coding scheme for identifying Pareto and rent-shifting amendments is limited by the information available. In reality Pareto-improvement can occur by degree – some amendments being more beneficial than others. Likewise, some amendments can be more rent-shifting than others. Our coding simplifies the amendment substance as either Pareto-improving or rent-shifting and does not distinguish effects in degree. Without being privy to the actual negotiations, it is certainly possible that we are missing some important contextual information.
As for future research, at least three avenues of additional analysis may be fruitful. Future PRT research should account for the degree to which amendments are mutually beneficial and the degree to which amendments provide one-sided benefits. In addition, our data do not distinguish between typical for-profit businesses and non-profit organizations; such a distinction may be illuminating for further evaluating the claims that are central to literature on PSM. Lastly, examining the potential asymmetric effects of decision rights vs location of knowledge assets on the outcomes of public-sector contracting renegotiation is fertile ground for future research.
Key constructs – data sources and coding examples for dependent variables
|Construct||Data sources||Coding guidelines, literature support, examples||Binary coding|
|Pareto-improving||Initial Contract and Contract Amendment||Pareto-improving amendments clarify terms or extend the contract under the same terms and conditions. These amendments improve the welfare of one party without worsening the position if the other. This description consistent with Guasch et al. (2007, 2008). Similarly, the description is consistent with references to post adjustments as mechanisms for hazard equilibration (Guasch et al., 2008; Williamson 1985) resulting from learning. (Mayer and Argyres, 2004). Operationalization is consistent with Segal (1999) and Susarla
Example: initial contract provides for remuneration not to exceed $12,000 to evaluate program performance over 2 months. Amendments provide for additional 25,000, extends additional evaluation period 2 more months and requires new reports and requires contractor to attend status meetings
|1= Pareto-improving; 0=not Pareto-improving|
|Rent-shifting||Initial Contract and Contract Amendment||Rent-shifting amendments improve the position of either the government or the supplier but not both. This description consistent with Guasch et al. (2008) and Suslara (2009). Rent-shifting amendments include changes in remuneration (increases or decreases) without changes in the scope of duties, or changes in the scope of duties (increases or decreases) without changes in remuneration
Example 1: Initial contract pays contractor at $150.00 per hour (not to exceed $18,000) for consulting. Amendment stipulates an hourly rate of $180.00 per hour (not to exceed $18,000) and does not add to consulting duties.
Example 2: initial contract pays contractor at $80.00 per hour to review applications. Amendment pays contractor same hourly rate and adds requirement that contractor submit monthly reports and file paperwork to comply with new state regulation
|1= rent-shifting; 0= not rent-shifting|
Note: Amendments that either correct minor mistakes in the original contract or add boilerplate provisions required by government regulations after the execution of the original agreement are not considered Pareto-improving or rent-shifting
Key constructs – data sources and coding examples for primary independent variable: integrationa
|Construct||Data sources||Examples contract language||Coding guidelines|
|Decision rights||Initial contract. Relevant Clause: key employee clause||Example: the parties have designated [person's name] as essential to the services offered. […] The parties agree that should such individual leave their employment during the term of this contract for whatever reason, the State shall have the right to terminate the Contract upon thirty days written notice.” “Substitution of another shall not be permitted without express written consent of the State”||Binary Coding for the presence of any of these clauses
1= rights reside with government; 0=rights reside with supplier
|Initial contract. Relevant Clause: Right to hire clause||Example: “If the State determines it would be in the best interest to hire an employee of the Contractor, the Contractor will release the selected employee from any non-compete agreements that may be in effect. The release will be at no cost to state or employee”|
|Initial contract. Relevant Clause: No right to sub-contract clause||Example: “Contractor will not subcontract any portion of the work without express permission of the State”|
|Initial contract and/or appendix. Relevant Clauses: Work scope, work description||Provisions that detail order of work tasks give authority over use of knowledge assets
Example: “Project work will be carried out in the following steps: “1. Get samples on p ricing […] 2. Coordinate review of […] 3. Seek guidance from national DEC expert […] 4. […]” “Reports will be provided at each project stage […] changes require express permission of the State”
|Knowledge Assets||Agency mission statements and program information from agencies’ websites; Contract work description, EDS form box 37||Example Language from Mission Statement: “The Indiana Department of Child Services engages with families and collaborates with state, local and community partners to protect children from abuse and neglect and to provide child support services
Coders matched work described in contract and in box 37 of contract EDS to agency mission statement and agency program information. Coders then answered “yes” or “no” to a series of questions: Does the contract refer to refer to the Medicaid program? Does the contract refer to Early Learning Program? The answer “yes” to any one of forty-five similar questions was used (by the authors) to determine if the contract task directly related to the mission of either the FSSA or DCS
|1= core services; 0= not core/ancillary|
Notes: aRelevant clauses determined by authors with advise from agency personnel and property rights literature; contract manual specifies paragraph number for clause and required language when clause is omitted
Distribution of contracts
|Government||A – Integration-government (n=81)||B – Non-integration (n=139)|
|Supplier||C – Non-integration (n=13)||D – Integration-supplier (n=26)|
Note: Number of contracts in parentheses
Distribution of contracts by amendment type
|Contracts amended||Pareto||Rent shifting||% Pareto amendments|
Note: The row labels refer to the cells identified in Table III
|Government-integration||0.261*** (0.0972)||0.234 (0.213)||−0.008 (0.213)||2.202*** (0.401)|
|Supplier-integration||−0.0662 (0.256)||0.841** (0.374)||−0.909*** (0.295)|
|Government decision rights||0.457*** (0.168)|
|Lobby||−0.750*** (0.150)||−0.675*** (0.207)||1.188*** (0.182)||−1.183*** (0.192)||−1.287*** (0.224)||−1.357*** (0.093)|
|Competition||−0.0888 (0.183)||−0.0971 (0.188)||−0.0692 (0.224)||0.02 (0.253)||0.099 (0.266)||−0.545 (0.341)|
|Contract experience||−0.00218*** (0.001)||−0.00219*** (0.001)||0.00232** (0.001)||−0.003*** (0.001)||−0.004*** (0.001)||−0.001 (0.002)|
|Work history||0.322*** (0.113)||0.314*** (0.115)||−0.123 (0.198)||0.466** (0.227)||0.436* (0.258)||0.011 (0.444)|
|Amount (ln)||0.0236 (0.0739)||−0.0008 (0.0863)||0.0918 (0.0787)||−0.269** (0.117)||−0.206 (0.130)||−0.519*** (0.189)|
|Constant||0.309 (0.973)||0.619 (1.089)||−3.441*** (1.331)||5.804*** (1.906)||4.431** (2.090)||7.336** (3.127)|
Notes: Robust standard errors in parentheses; includes a set of dummy variables for year. *p<0.1; **p<0.05; ***p<0.01
For example, Roberts and Sufi (2009) observe that over 90 percent of long-term debt contracts are renegotiated prior to their stated maturity.
Property rights theory is a prominent example, especially the work of Grossman, Hart and Moore (Grossman and Hart, 1986).
The term “professional services” varies by state, but the typical definition refers to services by persons uniquely trained or skilled. Providers include persons licensed, certified or registered such as attorneys, expert witnesses, architects and counselors but can include others the state deems distinctly qualified. See, for example, Indiana Code: IC 25-4-13-1-22.
Hart acknowledges the importance of both physical assets and human assets.
The present research focuses on forms of integration. We state the definition of non-integration only to clarify and distinguish the construct from integration.
The broader literature on public–private distinctions goes back a long way. For an early synthesis of the literature see Backoff and Levine.
Before DCS was formed in 2005, many of its services were provided by FSSA. The two agencies still collaborate on the delivery of many programs. Social service agencies like FSSA and DCS can also be differentiated from regulatory agencies or agencies that mainly provide support for other government agencies.
The advantages and disadvantages of our selection strategy are noted in the conclusion of the paper.
The authors have spent over five years studying the specifics of Indiana contracts for professional services because the state’s database makes available the full text of all contracts, which is rare. It also took considerable time to understand the state’s contracting policies and the meaning of specific contract language. Ichniowski and Shaw call this approach insider econometrics.
We achieved a Holsti score of0.89; the score reflects the “proportion agreement observed” by the coders (1.00=perfect agreement) (see Neuendorf, 2002, p. 149).
We relied on Neuendorf (2002) for general guidelines on coding text and for assessments of validity and inter-coder reliability. We followed Anderson and Dekker (2005) and Ryall and Sampson for more specific advice on coding contracts. Additional detail on our coding practices and coding forms, as well as assessments for inter-coder reliability and validity are available from the authors on request.
We decided to focus on key employee provisions as a crucial decision right after consultation with government employees and suppliers.
Unless otherwise specified, control variables are coded from a textual analysis of contract documents and from the Executive Summary Document (EDS) associated with the contract.
A lobbyist is defined as “any individual who is paid at least $1,000.00 to try to make contact with an executive branch agency for the purpose of trying to influence the outcome of a contract; a lease; another financial arrangement; or a rule” (25 IAC 6). The rule was first adopted on December 12, 2005. Modifications were adopted on March 10, 2008 (filing fee), January 2, 2007 (annual report) and July 10, 2012.
The hypothesis test of p=0 (prob>χ2=0.012) suggests separate probit estimations over a biprobit approach.
We use Stata’s vce cluster option to relax the independence assumption required by the probit estimator to independence between clusters, in this case the two agencies: FSSA and DCS.
In the standard Grossman, Hart and Moore (Grossman and Hart, 1986) framework, the allocation of rights itself defines and differentiates public from private. For example, Hart, Schleifer and Vishny model the dichotomous choice between direct service and privatization of prison services, which comes down to a tradeoff between lower cost and quality.
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