DESIGNING CONTRACTS FOR COMPLEX SERVICES
| Published date | 01 September 2014 |
| Date | 01 September 2014 |
| DOI | http://doi.org/10.1111/padm.12004 |
doi: 10.1111/padm.12004
DESIGNING CONTRACTS FOR COMPLEX SERVICES
DEANNA MALATESTA AND CRAIG SMITH
In this article, we employ transaction cost economics and the contingency stream of organiza-
tion theory to answer two related questions. First, when contracting for complex services, do
governments design contracts for flexibility? Second, is the contingency perspective relevant to
understanding contract design? Examining 130 professional service contracts awarded by state
government agencies in the USA, we find that task complexity and task unpredictability, two
dimensions of task uncertainty, increase the probability of flexible governance. This research high-
lights for managers the important fact that the potential for opportunism and task complexity are
different sources of uncertainty that pose different challenges and call for different governance
solutions. The study enriches our understanding of transaction costs by probing the conditions
under which task uncertainty matters most (and least), and further shows the utility of integrating
transaction cost economics with contingency theory to better understand contract governance.
INTRODUCTION
Governments rely on contractors for an increasingly complex array of services. In fact,
the number of contracts awarded by governments for complex services continues to
increase in both developed and developing countries (Marques and Berg 2011), a trend
that will likely continue as long as the preference for ‘a lean state’ also endures (Metz
1998). This phenomenon is not only ubiquitous but also results in challenges for public
managers, since there are numerous ways to design cooperative relationships between
public authorities and private parties. Public–private partnerships (PPPs), regulation by
contract, and voluntary agreements are just a few of the many ways that relationships
can be structured to combine actors and resources across sectors to solve complex
problems. In short, as the problems become more complex and the ways to structure
relationships become more varied, the written agreements to address them also become
more challenging.
To date, best practices offered for structuring written contracts typically concern
issues of control and accountability. For example, a number of scholars point out the
difficulties associated with measuring performance in these contracts and recommend
frequent reporting and monitoring (Prager 1994; Sclar 2000; Fernandez 2007). Others
recommend that managers use precise, detailed, and comprehensive language to avoid
misunderstandings (see Fernandez 2007, for a review; see also Romzek and Johnston
2005). Encompassing both lines of reasoning, Frederickson et al. (2012) submit that the
contracting literature (in public administration) is essentially an extension of the theory
of bureaucratic control. However, control is just one of several challenges for public
managers aiming for contract effectiveness. Complex services also pose problems for
information processing and coordination.
As contracting becomes more complex, reliance on expert knowledge becomes increas-
ingly valuable. Special problems arise, however, when the government relies on other
entities for the production, application, and transfer of knowledge. When contractors
possess valuable knowledge there is always a concern that information asymmetry can
Deanna Malatesta is at the School of Public and Environmental Affairs, Purdue University, Indianapolis, Indiana, USA.
Craig Smith is at the School of Government and Public Policy, University of Arizona, Tucson, Arizona, USA.
Public Administration Vol. 92, No. 3, 2014 (531–548)
©2014 John Wiley & Sons Ltd.
532 DEANNA MALATESTA AND CRAIG SMITH
lead to moral hazard. Therefore a main concern has been with designing contracts to
include effective control mechanisms. What is often overlooked or underemphasized is
the need to grant the experts flexibility in decision-making. As economists point out, the
costs associated with the transfer of idiosyncratic knowledge can be prohibitive (Hayek
1945; Jensen and Meckling 1998). The efficient and effective transfer of specialized knowl-
edge requires the collocation of decision authority with the knowledge that is valuable
to those decisions (Jensen and Meckling 1998). As a result, government should be just
as concerned with designing contracts for complex services to include decision-making
flexibility as they are with designing them for control.
To date, most scholars have relied heavily on transaction cost economics (TCE) to under-
stand contract design choices (Macher and Richman 2008) and why contracts are designed
for control (Ponomariov and Kingsley 2008; Reeves 2008; Fernandez 2009; Amirkhanyan
2010; Yang and VanLandingham 2012). Indeed, the theory’s underlying behavioural
assumption of opportunism underscores the importance of governing with accountabil-
ity, a long-standing concern in public administration. Unfortunately, TCE does not provide
clear guidance for parsing different forms of uncertainty; nor does it elucidate how differ-
ent contract solutions may facilitate information processing and coordination, which are
just as important to contracting as accountability. The empirical evidence linking various
types of uncertainty to governance solutions is also mixed (Macher and Richman 2008).
In contrast, there is a long tradition in organizational theory that connects tasks and
functions to governance structure (Barnard 1938; Burns and Stalker 1966; Thompson
1967; Galbraith 1977). According to the contingency perspective of organizational theory,
managing in a dynamic environment requires an ‘organic’ structure that incorporates role
flexibility rather than functional specialisms (Burns and Stalker 1966). The preponderance
of empirical evidence over the past 50 years suggests that this is sound advice for
designing the administrative apparatus of large-scale organizations subject to uncertainty
(Aiken et al. 1980; Covin and Slevin 1989; Aiken et al. 1980). But is this also the right advice
for designing decision systems within contracts?
A main premise of this research is that a theory of governance requires the integration of
several perspectives (Poppo and Zenger 1998). Accordingly, we rely on both TCE and the
contingency stream of organization theory to answer two related questions. First, under
conditions of task uncertainty do governments design contracts for flexibility? Second, is
the contingency perspective relevant to crafting the decision-making parameters within
contracts? One hundred and thirty professional service contracts awarded by state
governments in the USA provide the backdrop for analysis. Our main finding is that task
complexity and task unpredictability, two dimensions of task uncertainty, increase the
probability of flexible contracts. Our unique contribution is to propose and empirically
confirm that decision-makers give priority consideration to information and coordination
costs, over other types of transaction costs, under conditions of task uncertainty.
Although our analysis is conducted with a limited sub-sample of Indiana state contracts
for professional services, we believe this is a valuable first step to confirming the scope
conditions associated with transaction cost theory as it probes the conditions under which
task uncertainty matters most and least. It also provides preliminary evidence that the
contingency stream of organizational theory is relevant to contract design choices. We
believe our findings have implications for designing public sector contracts for complex
professional services regardless of the level of government or jurisdictional location.
This article proceeds as follows. In the next section we summarize the logic and
empirical evidence linking various sources of uncertainty and governance for both
Public Administration Vol. 92, No. 3, 2014 (531–548)
©2014 John Wiley & Sons Ltd.
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