The provision of public services by government funded decentralized agencies

Public services are often provided by lower level agencies that are funded by higher level government. Since markets for such services do not exist, n ormal pressures to minimize costs do not operate; indeed, usually these cos ts are unobservable. We study a principal-agent model which emphasizes the distinction between the financing and provision of public services. Two bro ad situations are analyzed: (i) the agencies are induced to reveal true cos ts; and (ii) in addition, to minimize costs, agencies must be induced to ex ert effort. The characteristics of the optimal funding contract and the mar ginal cost of public funds are derived in each case.