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SECTION 12 Issues in the implementation of market mechanisms This section provides additional details from the economic literature reviewed in Part III on the main issues involved in the implementation of market mechanisms. Properly applied, market mechanisms can lead to a more efficient and often more user-friendly system than under a traditional public policy system. However, implementing these mechanisms is rarely straightforward and runs the risk of introducing market failures as well as market benefits into the public sector. In this section we discuss issues that can arise in implementing each of the market mechanisms, focusing on the potential problems highlighted by theory. We also suggest ways in which these issues can be addressed and review the available evidence on the overall performance of each mechanism. Competitive tendering of service provision MARKET POWER The benefits from a competitive tendering process can only be realised if there is genuine competition for the contract. However, if the process does not elicit genuine competition, either due to market power by a single firm, or due to collusion amongst potential bidders, then an optimal result is unlikely to be obtained. As a result, prices may be higher and quality may be lower than under government provision. Unless there are other benefits such as improvements in consumer choice, it is possible that consumer welfare may be reduced under the market mechanism compared with government provision. Single firm market power When conducting a competitive tendering process it is important to ensure that there will be competing bidders. This outcome is highly unlikely where only one firm is in a strong position to win the contract. This situation can arise for a number of reasons – there may be only one firm which is genuinely able to fulfil the requirements, the contract may be structured in such a way that only one firm is in a credible position to bid, or there may be strong incumbency advantages. If there is only one firm that is able to provide the required service, then it is debatable whether a competitive tendering process is appropriate. However, in some cases, this problem may be solved through appropriate structuring of the 170
contract. In particular, dividing the contract into a number of distinct separate contracts may elicit greater competition. Although there may be only a limited number of bidders able to compete for a national contract, many more firms able to offer a service on a local or regional basis. In other cases, although there may be adequate competition when the contract is first awarded, in subsequent tenders the incumbent may have secured an advantage that prevents a competitive outcome. These incumbency advantages can arise if there is learning-by-doing or if the winning bidder undertakes specific investments. An incumbent could also earn a good reputation or develop a good understanding of the public sector and its requirements, which could create a strong advantage if the government agency is risk-averse. The reduced competitive discipline resulting from incumbency advantage will undermine the efficiency incentives that competitive tendering aims to encourage and could result in the government paying too high a price for the outsourced services. Moreover, these problems may be further compounded if the incumbency advantage is perceived by rival bidders. Weaker firms may not be willing to undertake the costs associated with compiling a tender if the incumbent is sufficiently well positioned to win the contract. This incumbency advantage discourages new entrants from participating in future tenders, restricting competition in the long run. Solutions to incumbency advantages Section 12 – Issues in the implementation of market mechanisms A number of different methods have been suggested to reduce the potential for incumbency advantages. One approach is to offer multiple contracts and award them to different bidders, setting limits on how many contracts any one firm is allowed to hold. Although this may mean the lowest-cost bidder is not always selected, cost savings are likely to be realised in the long run by ensuring future competition for the market. Awarding multiple contracts facilitates competition in subsequent stages because it allows for more than one firm to develop relevant expertise that can be drawn upon when the contract is re-tendered. Aggregating requirements into a single tender, on the other hand, allows only one firm to gain the incumbency advantage, reducing the ability of other firms to compete effectively in the future. Multiple contracts also help mitigate cases where one firm has gained market power through another means. Offering a number of contracts and stipulating how many each firm may hold increases the probabilities of success for other firms and potential entrants. This approach makes them more likely to incur the costs of bidding, increasing competition for the market and reducing rents to the advantaged incumbent. Seshandri et al (1991) 183 develop a model in which the level of aggregation of the contract determines the number of participating bidders, and find that multi- 183 Seshandri, S., K. Chatterjee and G. Lilien (1991), ‘Multiple Source Procurement Competitions’, Marketing Science 10. 171
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DTI ECONOMICS PAPER NO.14 Public Po
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DTI ECONOMICS PAPER NO.14 Public Po
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Contents Acknowledgements vi Forewo
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Contents Section 11 Emissions Tradi
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Foreword There is increasing intere
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SECTION 1 Introduction and summary
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Public Policy: Using Market-Based A
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SECTION 2 Using market mechanisms U
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SECTION 3 Lessons for the design an
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SECTION 4 Introduction This part of
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SECTION 7 Market-Based Mechanisms W
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SECTION 8 Framework for assessing m
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Part IV Case Studies 73
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● the Green and White papers behi
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A prison failing to deliver on its
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Table 9.3 Companies providing priso
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Section 9 - Competitive Tendering o
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detect any deviation from a collusi
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at HMPS began as an equal mix of th
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(e.g. lighting). This impact could
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MARKET POWER The full benefits of c
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However, it should be noted that te
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on competition is uncertain. The ab
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Controlling for problems of asymmet
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Procurement process design One way
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however, financial deductions are m
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The Independent Monitoring Board at
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Figure 9.1: Difference between the
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‘While there were staff in the pu
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design the invitation to tender and
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and demand conditions. Second, we d
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DEMAND Anyone can apply to a local
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● Rent deposit guarantee by the l
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