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Public Policy: Using Market-Based Approaches sourcing will increase participation at the cost of higher prices. However, Perry and Sakovics (2003) show that this is true when the number of bidders is fixed, but not when letting multiple contracts can attract entry. In this situation, multiple contracts can lead to lower costs, particularly if the number of initial bidders is small. 184 They also show that it will never be optimal to split requirements equally as this would allocate the largest possible demand to the most inefficient supplier, maximising productive inefficiency. It would also create the weakest incentives for competition for the primary contract. They advocate a split that involves the minimum size of secondary contract required to attract an additional bidder to the market. Maintaining bidding parity may be difficult even when the buyer sources from multiple suppliers. Sheang (2000) notes that multi-sourcing is sustainable in the long run only if the learning-by-doing advantage is equal across suppliers. 185 If this is not the case then the cost of multi-sourcing increases as cost differences between suppliers increase. Sheang recommends learning-by-doing advantages be equalised by splitting contracts equally amongst suppliers, even though this means productive inefficiency for the first tender is maximised and competition is weakened. Together this literature suggests that when incumbency advantages are a real concern, it can be better to award contracts to multiple bidders to minimise incumbency advantages. Contract length can also be helpful in reducing incumbency advantages. Although a long contract length means that an incumbent may have significantly more experience than a new entrant, a long contract also increases the incentives for new entrants to invest in bidding and to develop the skills. Newbery (2004) looks at the interaction between contract design and market structure in the context of the restructured and privatised electricity industry in England and Wales. He notes that the use of long-term contracts encouraged entry of new merchant Independent Power Producers by reducing uncertainty. The terms under which the contract is offered can also affect the level of incumbency advantages. A fixed-price contract exposes the bidder to the fact that costs may be uncertain ex ante, giving incumbents an informational advantage regarding costs. A cost-plus contract removes this advantage, but introduces problems of its own, as firms have no incentive to control their costs and so may engage in excess investment and gold-plating of services. In other cases, where incumbency advantages are recognised, it may be worthwhile for the government to take special steps to ignore the incumbency advantage when re-contracting. Cabral and Greenstein (1990) cite an example of the purchasing of computer equipment by the US government. 186 In the 1970s 184 Perry, M. and J. Sakovics (2003), ‘Auctions for Split-Award Contracts,’ The Journal of Industrial Economics 2. 185 Sheang, K. (2000), ‘Production Cost, Transaction Cost, and Outsourcing Strategy: A Game Theoretical Analysis’, mimeo, National University 186 Cabral, L. and Greenstein, S. 1990. Switching costs and bidding parity in government procurement of computer systems. Journal of Law, Economics and Organisation 6 172
the US Government procurement procedure for mainframe computers ignored the often substantial conversion costs involved in changing from one system to another and instead opted for the system that bid the lowest. Following much criticism from the individual Government agencies that had to bear the conversion costs, this system was changed in 1980 to one where estimated switching costs were added to incompatible vendors’ bids. Cabral and Greenstein find that centralised procurement, where conversion costs are ignored, elicits more competitive behaviour from the bidder who has a competitive advantage. Although on a local level the decision to ignore switching costs may appear suboptimal, at a global level this policy can be optimal as it induces lower prices as a result of more competitive bidding. Consequently, it is not clear that taking switching costs into account is always an optimal policy for customers. Collusion Section 12 – Issues in the implementation of market mechanisms Collusion arises when the firms in a market realise that they are collectively better off by ceasing to compete aggressively, and instead co-ordinate their behaviour to raise prices and maximise the profits of all. Collusion has been a cause for concern in many procurement processes. 187 In order for collusion to occur, the firms in an industry must be able to explicitly or tacitly reach an agreement on how to share the market. Such an understanding can be reached in a number of different ways, such as agreeing to keep to a particular geographic area (geographic market sharing), or reaching an understanding on the price to be charged. Moreover, for collusion to be successful it has to be sustained over time. Within collusion there is always an inherent tension between individual and collective interests. Whilst collusion may be in firms’ collective interests, at any point in time, firms have an individual incentive to ‘cheat’ on the collective agreement to increase their sales. For example, consider the situation where firms have colluded to raise prices significantly above the competitive level. If any one firm cheats by offering a price just below the cartel price, then it can steal significant sales from its rivals. As a consequence, economists have found that collusion can only be sustained if firms that deviate from the collusive agreement can be detected and punished by other cartel members. 188 187 McMillan, p. 1991. Dango: Japan’s price fixing conspiracies. Economics and Politics 3. Porter and Zona. 1993. Detection of bid rigging in procurement auctions. Journal of Political Economy 101. Pesendorfer, M. 2000. A study of collusion in first price auctions. Review of Economic Studies 67. 188 Motta (2004), Competition Policy: Theory and Practice, Cambridge University Press. 173
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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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The Green Paper stated the Governme
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Page 143 and 144: Controlling for information problem
Page 145 and 146: extent though, it was competition b
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Page 149 and 150: levels are reducing and new tenants
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Page 171 and 172: consultants to Defra of £11 per to
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