Public Policy: Using Market-Based Approaches - Department for ...

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