In both developed and developing countries, governments finance, produce, and distribute various goods and services. In recent years, the range of goods provided by government has extended widely, covering many goods which do not meet the purist's definition of “public” goods. As the size of the public sector has increased steadily there has been a growing concern about the effectiveness of the public sector's performance as producer. Critics of this rapid growth argue that the public provision of certain goods is inefficient and have proposed that the private sector replace many current public sector activities, that is, that services be privatized. Since Ronald Reagan took office greater privatization efforts have been pursued in the United States. Paralleling this trend has been a strong endorsement by international and bilateral donor agencies for heavier reliance on the private sector in developing countries.

However, the political, institutional, and economic environments of developing nations are markedly different from those of developed countries. It is not clear that the theories and empirical evidence purported to justify privatization in developed countries are applicable to developing countries.

In this paper we present a study of privatization using the case of Honduras. We examine the policy shift from “direct administration” to “contracting out” for three construction activities: urban upgrading for housing projects, rural primary schools, and rural roads. The purpose of our study is threefold. First, we test key hypotheses pertaining to the effectiveness of privatization, focusing on three aspects: cost, time, and quality. Second, we identify major factors which affect the performance of this privatization approach. Third, we document the impact of privatization as it influences the political and institutional settings of Honduras. Our main finding is that contracting out in Honduras has not led to the common expectations of its proponents because of institutional barriers and limited competitiveness in the market. These findings suggest that privatization can not produce goods and services efficiently without substantial reform in the market and regulatory procedures. Policy makers also need to consider carefully multiple objectives at the national level in making decisions about privatization.