| Published: | August 18, 2010 |
| Paper Released: | July 2010 |
| Authors: | Lamar Pierce and Michael W. Toffel |
Executive Summary:
Governments have long debated which tasks should be outsourced to the private sector. Although often justified on the basis of the cost-efficiencies of market competition, outsourcing to private firms carries its own risks, which can reduce the quality of services provided. In addition to more conventional services such as garbage and recycling collection, some governments outsource the enforcement of laws and regulations. This paper by Olin Business School's Lamar Pierce and HBS professor Michael W. Toffel examines the automobile emissions testing market in one state where this form of regulatory enforcement has been outsourced to the private sector. Their analysis illustrates the importance of considering organizational scope and private governance mechanisms such as monitoring provided by corporate headquarters and independent third-parties in efforts to assure the reliability of firms that provide outsourced services. Key concepts include:
- The risk of poor enforcement quality is greatest among firms whose organizational scope includes products and services where enticing customer loyalty can enhance profits.
- Enforcement quality is higher at subsidiaries and branded affiliates than at independent facilities. Because subsidiaries and branded affiliates will face worse consequences if leniency were to be exposed, they are more likely to invest in private governance mechanisms including standard operating procedures and internal policing.
- Third-party certification of related services can also be an indicator of higher enforcement quality.
Abstract
Profit-seeking firms can present efficiency improvements when performing functions traditionally relegated to government. Yet these potential cost-efficiencies from market competition are often offset by poor enforcement quality resulting from moral hazard, which can be particularly onerous when outsourcing enforcement of government regulation. In this paper, we argue that the considerable moral hazard of private regulatory enforcement can be mitigated by the scope of organizations' product/service portfolios and by private governance mechanisms. These organizational characteristics affect the stringency of enforcement through reputation and customer loyalty, differential impacts of government sanctions, and standardization and internal monitoring of operations. We test our theory in the context of vehicle emissions testing in a state in which the government has outsourced inspection and enforcement to private sector establishments. Analyzing millions of emissions tests, we find empirical support for our hypotheses that particular forms of firm governance and product portfolios can mitigate moral hazard. 45 pages
Paper Information
- Full Working Paper Text
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- Working Paper Publication Date: July 2010
- HBS Working Paper Number: 11-004
- Faculty Unit: Technology and Operations Management
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