Measuring and Managing Ex Ante Transaction Costs in Public Sector Contracting

• Date: 01 September 2019
• Author: Matthew Potoski,Erik Baekkeskov,Ole Helby Petersen,Trevor L. Brown
• DOI: http://doi.org/10.1111/puar.13048
• Published date: 01 September 2019

Measuring and Managing Ex Ante Transaction Costs in Public Sector Contracting 641

Trevor L. Brown is dean of the John

Glenn College of Public Affairs, The Ohio

State University. He conducts research

and teaches on public management and

leadership, governance, government

contracting, public-private partnerships,

and democracy and democratic transitions.

E-mail: brown.2296@osu.edu

Matthew Potoski is professor in the

Bren School of Environmental Science and

Management, University of California, Santa

Barbara. He is coauthor of

The Voluntary

Environmentalists

(Cambridge University

Press, 2006) and

Complex Contracting

(Cambridge University Press, 2014) and

has written on a variety of topics, including

businesses environmental strategies,

environmental policy, and public and

nonprofit management.

E-mail: mpotoski@bren.ucsb.edu

Erik Baekkeskov is senior lecturer

in public policy and political science at

the University of Melbourne, Australia.

His research interests include public

administrative reforms and public policy

making.

E-mail: erik.baekkeskov@unimelb.edu.au

Abstract: Transaction cost attributes, such as the complexity of the product being purchased, shape the risk that

government contracts will fail. When transaction cost risks are particularly strong, a common prescription is to avoid

contracting altogether or, if it is unavoidable, to spend additional resources on contract management activities. This

article presents evidence on the size and variability of governments’ ex ante transaction cost spending, using original

data from 72 contracts issued by 47 Danish local governments. Ex ante transaction costs average 2.7 percent per

contract and are relatively higher when services are more complex and lower when governments have prior contracting

experience and contracts were larger. The analyses suggest the importance of distinguishing between transaction cost

attributes and governments’ choices to spend resources in response to them. Effective management spending in the face

of transaction costs can help governments organize and capture value from contracting with private businesses.

Evidence for Practice

• Danish local governments spend 2.7 percent of contract value on ex ante transaction cost expenditures.

• Ex ante transaction cost spending varies in response to the complexity of the product, the size of the contract,

the government’s fiscal capacity, and the government’s contracting experience.

• Governments’ transaction cost spending reflects transaction cost attributes that influence the risk of negative

contract outcomes.

Governments often look to reduce costs by

purchasing products and services instead of

making them, under the idea that market

competition among suppliers drives down prices

(Sclar 2000; Van Slyke 2003). When governments

purchase a product or service, part of the overall

cost is the resources it expends on finding and

selecting vendors, negotiating contract terms,

monitoring vendor performance, and ensuring

that the delivered product meets specifications—

items that are collectively referred to as transaction

costs (Williamson 1996). At first glance, spending

motivated by transaction costs can seem wasteful—it

raises the total cost without directly increasing the

amount or quality of the purchased product. On

closer scrutiny, however, transaction cost spending

can be essential for mitigating risk and ensuring

that contracts produce value. For instance, without

proper care in writing and monitoring a refuse

collection contract, the vendor may fail to pick up

garbage on a regular schedule or return bins to their

proper locations. Getting the right contract terms

may be even more important for products that

are more complex, such as eldercare programs or

information technology systems (Brown, Potoski,

and Van Slyke 2010).

An important objective in contract management is to

allocate resources and establish procedures to manage

contract risk and improve contract value. The nature

of this challenge depends on characteristics of the

product and circumstances of the contract—what

are sometimes called transaction cost attributes

(Williamson 1979, 1991, 1996). The practice of

contract management can be challenging for several

reasons. First, unlike purchasing costs, where prices

tend to be negotiated and posted, transaction cost

spending can be more difficult to observe and

measure. Such spending tends to be dispersed across

budget categories and involves less tangible resources

such as time, effort, and expertise. Second, the

need for transaction cost spending is highly variable

across products and circumstances; the need is lower

for simple products that are commonly bought

and sold in robust markets, and the need is higher

for complex products that must be designed and

produced for the purchaser’s unique requirements

(Levin and Tadelis 2010). Finally, while spending

on some transaction cost items is inevitable, such

as specifying a refuse collection schedule, other

transaction cost spending can be managed, and

perhaps even reduced in some circumstances,

without sacrificing value.

Ole Helby Petersen

Roskilde University

Erik Baekkeskov

University of Melbourne

Matthew Potoski

University of California, Santa Barbara

Trevor L. Brown

Ohio State University

Ole Helby Petersen is professor of

public administration and director of the

Center for Research on Public-Private

Collaboration at Roskilde University,

Denmark. His research interests include

public sector contracting, transaction

costs, privatization, and public-private

partnerships.

E-mail: olehp@ruc.dk

Public Administration Review,

Vol. 79, Iss. 5, pp. 641–650. © 2019 by

The American Society for Public Administration.

DOI: 10.1111/puar.13048.

Measuring and Managing Ex Ante Transaction Costs in

Public Sector Contracting

Research Article