What kind of contractual problem is this? Oliver Hart, a Nobel Price winning economist, made the following case against privately founded prisons in an interview from 2017: “There are some things that are difficult to specify [in a contract between a government and a private prison]. One is the quality of the guards. A private company may have incentives to hire cheaper, less trained guards and yet still be within the contract.”

What is this type of contractual problem called? Why does it occur?



Hello everyone,

I'm struggling with the question above.
It is from and old exam in my lecture 'Organization and Management' (consisting mostly of contract theory).

I think the question is either aiming for:


'Incompleteness of contracts' since the "quality of guards is hard to specify". Probably because the quality is observable but not verifiable (or specifying the quality would be too costly) OR
'Adverse Selection' since the government does not know what kind of cost function a private company would have (for the quality of the guards) prior to signing the contract.


Now that I wrote that I feel like it must be the former just because it makes sense to me.

What do you think? May the contractual problem at hand also be something entirely different?

Thank you in advance,
Chris
This looks like a case of incomplete contracts, or what is sometimes known as non-contractibility.



In the principal/agent paradigm, adverse selection arises when an informed agent transacts with an uninformed principal and, in particular, the principal cannot distinguish between desirable and undesirable agent trading partners.

I don't think your example is a good fit for adverse selection: here the principal would be the government and the agent would be the prison company. But the quality uncertainty concerns the guards rather than the agent itself, and the government is not directly interacting with the guards here.

From the world of information asymmetries, this looks more like a situation of moral hazard where the agent is not incentivised to act in the prinipal's interests. Moral hazard is only really a problem when you Cann't write a contract stipulating thet the agent should behave in the principal's interests. This could be for various reasons


the agent's action can't be directly observed;
while the angel't action cab be observed, its badness can't be objectively verified (i.e., it can't be conclusively proven in court that the action was bad, so a court could never enforce the contract);
the number of contingencies is so large that it is impossible to write a contract specifying all of them
there is no relevant authority to enforce the contract (e.g., a drug dealer and his supplier can't write a meaningful contract because they can't exactly expect a court to enforce it)