Ministers have been privately advised to allow schools and hospitals to fail if the government is to succeed in its overhaul of public services, confidential government documents reveal.

The prime minister will today announce long-awaited plans to "end the state's monopoly" over public services and give people more "choice and control" over what they use, in a white paper opening up swaths of the public sector to private companies, charities and mutuals. David Cameron will claim that the welfare state is failing, and promise to "release the grip of state control and [put] power in people's hands".

Under the plans, communities will be allowed to set up neighbourhood councils to commission services on a hyper-local level, individuals will get more personal budgets to buy their own services and the use of payment by results will be expanded to encourage markets to develop across the public sector.

But documents obtained by the Guardian under the Freedom of Information Act reveal research by civil servants warning that markets are susceptible to "failure" and costs could in fact rise unless a true market is created by allowing public services to collapse if they are unsuccessful.

It opens up the potential for schools, hospitals, social care systems and nurseries to fold without the government stepping in to prop them up. Labour called it an "appalling revelation".

The open services white paper will be launched by the prime minister today in a speech in which he will say: "We've got a welfare state that doesn't deliver welfare, that doesn't get people back into work but traps them in poverty instead.

"So let me tell you what our change looks like. It's about ending the old big government, top-down way of running public services … releasing the grip of state control and putting power in people's hands.

"The old dogma that said 'Whitehall knows best' – it's gone. There will be more freedom, more choice and more local control. Ours is a vision of open public services." It is widely understood that the plans contained in the white paper have been downgraded since Cameron first revealed details in a speech in February, after an internal coalition battle with the Liberal Democrats, who have sought to ensure that any outsourcing and market-driven reforms maintain a strong degree of accountability. One Downing Street source described it as "more greenish than white" now. However, Cameron will say: "Let me assure you of this: we are as committed to modernising our public services as we have ever been."

The documents obtained by the Guardian were prepared by civil servants as part of an internal government review into the consequences for democratic accountability of the coalition's localism, big society and outsourcing reforms that are integral to today's white paper.It was ordered by the cabinet secretary Sir Gus O'Donnell.

One paper on "the role of choice and competition in driving value for money in public services" warns that if more suppliers move into the public sector, costs could rise.

"This problem is mitigated if the system allows for provider exit as well as entry – and indeed the evidence suggests it is exit which drives efficiency ... There is also evidence from the private sector that a significant share of productivity growth is due to entry and exit processes.

"But exit of providers (eg school closure) may be controversial and unpopular and an appropriate failure regime must be designed," it warns.

The document also:

• Concludes there is a benefit in choice and competition in driving up standards, but that it works best where there are fixed prices in health for operations, or in education per pupil, otherwise there is a risk that companies will simply compete by undercutting each other. Drawing on evidence from the first major wave of privatisation in the 1990s, it says "providers will compete on price but quality may suffer".

• Highlights the potential for "market failures" in the public sector, saying some areas may not be appropriate. "In particular, it is worth noting that if the service is complex; time-critical; and used infrequently, (for instance accident and emergency services), it may be difficult for users to make an informed choice."• It warns that wealthier people may be better placed to exercise choice in which services they access, because they are more likely to be able to travel further for the school or hospital they want.

Tessa Jowell, the shadow cabinet office minister, said that the potential for allowing schools and hospitals to collapse was "an appalling revelation".

She said: "The education of children and the treatment of the sick should not be treated as a commodity to be traded, as if healthcare and educations were chocolate bars or washing powder."

A Downing Street source said: "The paper will set out that there will always be a role for external bodies independent of government – regulators – with powers to ensure proper financial management and to intervene to ensure proper continuity of service."