Theory of the Firm: Privatization of correctional facility
1. Introduction and problem statement
The Danish department of correctional facilities have decided to bring in OrgDesign Assoc. to
advise them on the optimal way of engaging with private correctional facilities. I have been
asked to evaluate the test project and provide recommendations with a long-term perspective.
I will use principal agent theory and transaction cost theory to address the contractual
relationship between the government and the private contractor. Transaction cost theory will
also be the framework when discussing and recommending the optimal governance structure,
with the support of elements from ownership rights theory.
According to the problem statement, the main motive for exploring privatization is to curb
demand. Cost efficiency is secondary since there is no indication of financial problems. There
are two main factors contributing to increased demand: the lowered minimum age (initial
jump) and the extended sentences for serial offender (increasing rate). The objective should
then be to curb demand without compromising rehabilitation. Demand can be curbed by
engaging with private firms or by internalizing the service. The government is welfare
maximizing (low incentives), while the firm is profit maximizing (too high incentives) and
costs have an adverse effect on quality (H, S, V, 1997). Furthermore, A prison is seen as one
asset, where efficiency depends on two specific investment, confinement and rehabilitation.
These assumptions in additions to the objective, indicates that the government has to decide
which investment they value more and to which extent they can ensure rehabilitation in
private prisons. I assume that contracts are incomplete and that only residual rights can be
allocated between the parties. In extension to transaction cost theory, recommendations are
made from a market failure perspective.
2. Evaluation of the test-project